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.
Here’s an article in a similar vein that was pointed to on another blog:
U.S. Dollar Euthanasia While Finns Legislate Days-Off for Shagging
Posted April 18, 2008 | 08:11 AM (EST)
James Turk at goldmoney.com points out that throughout history people living in a country whose currency is dying are the last in the world to know. I suppose it’s like the husband who is the last to know his wife is cheating on him. What’s obvious to everyone else is impossible to imagine for the cuckold.
It is impossible for Americans to see that their currency, the U.S. dollar, is going the way of the Continental. Remember the Continental?
The Fed is not “pumping new dollars into the global economy at an astounding pace” or “continuing to flood the market with new dollars”.
You can’t trust the analysis of an economist who writes so ignorantly of how the monetary system actually works.
Anonymous said…on April 23, 2008 7:00 AM…the phrase “Pumping dollars” referenced by Benn Steil. I, too, don’t understand. Has the Fed already resorted to printing up dollars? Or does he mean “pumping up dollars” by selling an unlimited amount US debt that foreigners seem willing to exchange their currnecy for?
“The Fed is not “pumping new dollars into the global economy at an astounding pace” or “continuing to flood the market with new dollars”.”
What indicator are you using to assert that?
It is difficult to think of a scenario that would prevent further major declines in the $ in the near- and mid-term. Here are (some of) the immediate problems: a) US interest rates are too low relative to major competitors, b) we have a major deflation in $-denominated assets, both real and financial, c) our current account deficit is just bloody awful and not improving a bit despite slower consumer spending, d) key commodities priced in $ are going up and up, speculative or not, with no intervention coming from decision makers, e) revenues at the federal and state level are likely to be seriously decreased by asset deflation and recession, and f) we refuse to curtail the one major discretionary expense digging chunks in the public fisc [hint: it involves making other people dead and blowing things up].
Want to save the $? Then reverse all of those conditions, except the asset deflation which is irreversible. That would mean: a) raising the Fed funds to put a floor under the currency, c) some form of tariffs or taxes to drive down demand for some of those things we import but can’t afford, d) rationing most likely of crucial commodities, though other suggestions are welcome, e) raise frickin’ taxes ’cause we need some revenue, natch, and f) put the boys on the boat and sail for home, leaving all the junk stuck in the sand.
Can you imagine any policy maker in the US doing this? Well, I can: FDR. But he’s dust in the tomb, and nobody on hand or on the way has the cojones or vision to tell the country it is in a life-threat kind of situation. So nothing will be done. More accurately, all the wrong things will be done because that is exactly what is being done now.
It is not inconceivable that after a major crisis the $ might recover as the reserve currency in a decade or three. I’m skeptical, but this potentiality shouldn’t be ruled out. Our economy is large, and ultimately will substantially recover if we make the effort. But the world will be a (much) different place by then, and we’re out of practice playing catch up.
The FED does not target the supply of dollars but rather targets the rate banks charge each other for overnight reserves.
When people say the FED is pumping or printing money they probably mean that the FED is enabling money supply expansion by targeting interest rates at too low a level.
The end result though is the same. The supply of dollar increase.
I almost agree with you. My point is that people don’t “probably mean” because they don’t understand what the Fed does and doesn’t do. The broad money supply is almost entirely a function of commercial banking activity, including credit demand, which is partly a function of interest rates, which is obviously influenced by the Fed. But critics of the Fed confuse interest rate setting with money creation. There’s a lot more than the Fed involved in the money creation part.
binary options – no he doesn’t mean floating debt to foreigners.
francois – the Fed creates money in the form of the monetary base, the growth of which has been essentially flat for some time. But even if it weren’t flat, its not the source of the bulk of money creation. The monetary base is tiny in comparison with the broad money supply measures.
The Fed’s overiding influence is the Fed funds rate, not money creation. (Recently it has been substituting more credit risk for treasuries in its balance sheet asset mix, but this doesn’t affect its net money creation on the liabilty side.)
With an elastic currency the FED/government has the power to make credit and money equivalent.
We are seeing this process in real-time as the FED tries to manage the widening spread between the two. That is the whole point of TAF, TSLF, FNMA, FHLB, FRE etc….
These are creeping government guarantees from the treasury and the FED that make non government liabilities more acceptable.
I’ve never really understood the full meaning of the phrase “elastic currency”. Could you define?
But apart from that, TSLF, FNMA, FHLB, FRE etc. are effectively mechanisms for the Fed to shed assets in the form of treasury bonds (i.e. credit extended to the government) and replace them with assets in the form of credit extended to the private sector. This changes the Fed’s asset mix profile and its related credit risk, but it doesn’t change its liability mix profile, which is the money it has “printed”. Remember that any money potentially created by the new credit facilities has been neutralized (or “sterilized”) by reversing out of an equivalent amount of treasury asset positions. This leaves the money side of the balance sheet essentially unchanged.
I am not arguing the FED is printing money. Most money growth in the US is through the banking system. What the FED/treasury have done though is enable and guarantee the banking systems liabilites or credits. So thats what I mean by saying credit and money aren’t that different if the FED/treasury in extremis are willing to stand behind the banking system.
Thats why you shouldn’t look at M1 for clues about money supply growth. Look at broader monetary aggregates or other macro variables.
Elastic money is just another term for fiat, paper or non-commodity backed money.
Of course the Fed is pumping new money in the system – that is the meaning of the word ‘liquidity’. The Fed does not print the paper dollars, but that is a moot point. The net effect of the Fed’s easing is the increase in the supply of dollars, the dollars that are quickly converted to commoditties, other currencies, and such.
I bet Bernanke is quite surprised that his helicopter theory does not work as he envisioned. He thought that by magic the freshly printed Bernankes will pour back in the real estate, but for some reason they all went to euros, oil, grains, flour, metals, etc.
As of March 2008, Year-over-Year change in US M3 was +17.38%.
Either the Fed is seriously goosing the money supply or the Fed has completely lost control of the money supply.
I suspect the latter, which might explain why the Fed stopped reporting M3 just as Greenspan waltzed out the door. When in doubt hide the evidence, standard MO in Washington.
A Different Anonymous
MZM, M3 Show Flight to Safety
Anon said: “As of March 2008, Year-over-Year change in US M3 was +17.38%.”
Mish at globaleconomic says:
“Claims that those charts (M3) show hyperinflation, or even a rampant increase in money supply is typical of the half-baked analysis spawning all over the web. For starters MZM and M3 contain credit transactions and money equivalents, not money.
And the distinction between money and credit is a crucial issue. A rapid increase in money supply leads to a Weimar Republic or Zimbabwe hyperinflationary scenario, while a rapid increase in credit eventually leads to a Great Depression or Tulip Bubble collapse endgame.”
The ST Louis Fed’s own Base Money chart shows y/y growth close to zero.
I think its an important distinction. Mish makes a very strong case we are in a deflationary period, not inflationary, because credit (money) is being destroyed at a record pace.
Mish is a typical US-centric analyst. He thinks the heavily manipulated by the world governments US Treasuries market represents “safety”. He completely missed the euro rally, he completely underestimated the resolve of the ECB to fight inflation.
Gary North calls these people “deflationists in the second generation” – despite decades of substantial inflation, they still cling to Treasuries.
Gotta agree about the deflationists. I see the price of food and gas, hec even chinese manufactured goods going up in price. How anyone can call these events deflation is beyond me. An example I think of being caught in your own orwellian doublethink/speak. War is peace. Truth is a lie. Inflation is deflation.
Getting caught up in pet theories and trying to force events to your framework is no way to analyze anything.
Mish is in complete puzzlement concerning the US$ chart. Deflation would bring a rise in the value of the dollar. He keeps waiting for an up trend there and has the gull to say gold will rise with deflation.
The dollar itself is an instrument of credit as all fiat is. Issue to much credit and the wheels come off the factional reserve banking wagon.
Just because debt is being warehoused doesn’t mean it won’t come due.
It’s pretty obvious there is not enough fiat to service the debt. Inflation will be in demand to cover.
Hey! It sure would be helpful if you people posting as anonymous would choose some name to go by. Then it would be easier to pen replies to a specific person.
It’s real easy to do.
In the comment box, just click on the radio button that identified as “Name/URL”. Then type in your chosen name in the Name field. That’s all that you have to do.
Deflation is, of course, a canard. Pseudo-intellectual crackpots have been intermittently predicting deflation since the 1930s when the dollar was still somewhat formally anchored to gold.
The idea that any paper currency is in danger of appreciating systemically because of excessive debt must be too alluring a concept to overcome overwhelming evidence to the contrary.
Paper currencies don’t die off because they are appreciating too much, they die off because after repeated abuse with over issuance and neglect nobody wants or trusts them anymore.
Formerly shaky governments around the world are accumulating excessive dollar reserves at more rapid rates. Unfortunately, the wet dream of deflation is just that.
While the nature of debt deflation will clearly be quite different in a fiat based economy, it’s probably still dangerous to underestimate its power in an economy as heavily leveraged as the US. There’s also a danger of overestimating the Fed’s resolve (and capacity) to counter it.
For much of the last decade, the real monetisation has occurred offshore, which has, in turn, allowed the Fed to look virtuous. As noted in Yves’ post “US-China Co-Dependent Behaviour Worsens”, there’s little reason to rely on the indefinite continuance of this “happy” pattern (it’s nothing of the sort, of course, viewed from a slightly larger perspective).
The combination of the heavy lifting being done elsewhere and the market’s continuing (albeit finally diminishing) faith in the Fed has meant they could get by on largely symbolic acts. The point will come (and probably soon) where this is no longer so, when the Fed, and the markets, will have to face up to a much less palatable mix than the one they’re grumbling about now.