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After the dollar

May 10th, 2008

It’s unclear whether we are bound for a Post-American World in the near future, but it seems pretty clear that we are bound for a world in which the US dollar is no longer the unique ‘reserve currency’. The combination of chronically large trade and budget deficits and willingness of the US monetary authorities to tolerate sustained inflation means that decisions by national central banks to hold US dollar reserves are now driven by a desire to preserve the existing order rather than by calculations of risk and return. In the long run this can’t be sustained.

If the US dollar can no longer satisfy the requirements of a reserve currency, what are the alternatives? I can see two possibilities.

The first is the euro. At current exchange rates, which seem likely to persist for some time, the eurozone is the world’s largest economy. And the euro share of reserves has been growing. Still, neither of these, in isolation, would be enough to allow the euro to achieve the kind of dominance that characterized the dollar in the early postwar period (or, before that, the pound sterling). In each case, these currencies combined economic hegemony with imperial power.

The eurozone may be the worlds largest economy, but the EU is not an economic hegemon. Europe is a postmodern kind of empire, so the possible rise of the euro would not follow the flag as om the past. What’s more likely is the euro equivalent of dollarization, with the eurozone potentially expanding beyond the EU, along with a growing penumbra of currencies pegged to the euro or targeting a euro exchange rate. This would in turn encourage countries outside the euro area to hold euros as foreign exchange reserves. All of this would be of a piece with the differentiated expansion that has characterized European institutions of all kinds.

The second possibility is a world without a reserve currency. If the decline of the US dollar continues, we might see gradual diversification into euros and pounds, renewed holding of the yen as Japan recovers and, with the relaxation of exchange controls, increased holdings of rupee and yuan. In principle, given modern computing resources, there should be no problem in quoting prices in six different currencies simultaneously, or in one or more baskets of currencies.

Update Much the same thoughts from Peter Goodman in the NYT

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  1. swio
    May 10th, 2008 at 23:16 | #1

    “In principle, given modern computing resources, there should be no problem in quoting prices in six different currencies simultaneously, or in one or more baskets of currencies.”

    You are mixing up software and hardware costs. The extra computer power (ie hardware) required is trivial, but extra grunt is always a relatively cheap. The real cost is software, particularly updating the enormous amounts of custom written software used by every financial institution in the world. The cost of re-designing, re-writing and testing systems to work on multiple currencies would be enormous. Many millions of dollars for most financial institutions and easily tens of millions plus for banks the size of the four Australian majors depending on how extensive the changes would be. It is a very expensive and painful process to do major changes to a large and mature existing set of code.

  2. Father Mercy
    May 10th, 2008 at 23:16 | #2

    My money’s on the screen jockeys backing the Euro.

  3. Ian Gould
    May 10th, 2008 at 23:36 | #3

    “The combination of chronically large trade and budget deficits and willingness of the US monetary authorities to tolerate sustained inflation means that decisions by national central banks to hold US dollar reserves are now driven by a desire to preserve the existing order rather than by calculations of risk and return. In the long run this can’t be sustained.”

    Yes but it could be the US policy settings rather than the status of the dollar which change.

    The US was in a similar position in the late 1980′s – a bipartisan effort by the George HW Bush and Clinton administrations and the Republican-controlled house (from 1994 IIRC) restored the confidence in the dollar.

    I’m now going to get a bit more speculative: I’m not sure the status of the US dollar as an international trading currency is necessarily that closely linked to the US itself anymore.

    There’s a huge investment as Swio points out in software (and in human skills) for trading the dollar.

    Concerned about US inflation? By inflation-linked bonds or hedge your exposure with derivatives.

    Unhappy with US interest rates but want to park your money in US dollars? Buy USD-denominated Eurobonds.

  4. May 11th, 2008 at 00:35 | #4

    PrQ,
    I think you need to seperate two of the elements of a global reserve currency – amounts held by central banks as reserves and the way that commodities are traded and priced by the “screen jockies”.
    To me, central bankers tend to behave with “safety first” in mind. In the period from 1945 to now, none of them would have been sacked for holding USD. Win or lose on the strategy – it does not matter. It is safe, so it is held. This can be shown through the holdings of gold. Same drivers – everyone held gold, so it was not until there was a consensus reached to ditch gold that any was actually sold.
    The problem now is that, if there was a consensus reached to sell gold then the size of the over-hang would mean that the USD would collapse – meaning the strategy to sell USD (not the actual sale) would destroy so much of the value the central banks hold. As such this strategy is unlikely to be publicised – and only slightly less likely to eventuate.
    If this is done it will have to be done over decades to get rid of such holdings without really hurting the value of their existing holdings.
    The screen jockies can be less forgiving – but are also creatures of habit. If a commodity is traded in a currency there is really no need to swap – you can trade the commodity and swap the resulting currency exposure instantly into another currency – including your own.
    Why bother – just trade in the currency everyone else is (for liquidity) and then sterilise any exposure you do not want.
    Almost the same applies for anyone actually using or producing the underlying commodity. Producers and users are more exposed as they typically have much longer time horizons than the screen jockies – a mine or gas field will normally be production a bit longer than a screen jockey will be in a job. If there is to be a change, this would be my guess as to where it will gather momentum. As they change from basing their pricing on USD to other currenciesa new pricing regime may emerge – or, as you suggest, none at all. The only thing that would stop it is the fear of regulation hurting any particular currency.
    Personally though, I doubt it. It is just easier (and cheaper) to quote in one currency and then swap the exposure into whatever other currency you want. Maintaining liquidity in several currencies is expensive and spreads are likely to widen, making the whole thing more expensive for everyone.

  5. May 11th, 2008 at 09:38 | #5

    The combination of chronically large trade and budget deficits … In the long run this can’t be sustained.

    Australia also has a chronically large trade deficit, despite incredibily favourable terms of trade. Other energy and resource rich countries (e.g. Canada) are currently running large trade surpluses.

    Despite this, Australia’s currency has never been stronger. How long can our trade deficit be sustained? Its not exactly easy for non-resource exporters at the moment.

  6. Ian Gould
    May 11th, 2008 at 10:28 | #6

    The difference CS is in the causes of the trade deficit and what the money is being used for.

    The US government is borrowing abroad and using the money for current consumption.

    The Australian government is running large surpluses and much of the foreign money coming into the country is not loans but investment – and much of the money is going not into private consumption but into capital investment.

  7. conrad
    May 11th, 2008 at 15:07 | #7

    Its a sad state of affairs if the best two picks are the US (still) and the EU, especially if one considers where a lot of money is coming from to subsidize the US. Instead of just selling oil, most of the gulf states would do well to try to actually modernize their own countries, via decent schools, universities and the like, and I also find it hard to see why China needs to wander around the world looking for investments when there seem to be infinite places in China. If they did this, they might not actually need to invest in other people’s currencies and the like so much.

  8. May 11th, 2008 at 19:16 | #8

    Conrad,
    In the case of China as in many of the other nations in the area you mentioned, they are not concerned for their own peoples’ welfare, just their own power.

  9. charles
    May 11th, 2008 at 20:18 | #9

    Ian

    The currency used for trade doesn’t matter, as you point out you can trade out you exposure at whatever level you want. It’s the currency people hold that matters. People holding US dollars have over the past 12 month lost a lot of money, and will probable lose more in coming months. Losing money is not a good outcome.

  10. charles
    May 11th, 2008 at 20:34 | #10

    Conrad

    You need to visit China, one of the reasons China is difficult to deal with at the moment is their drive for full employment. Yes unlike Iran they don’t have democracy, but that doesn’t naturally lead to you conclusion.

  11. Joseph Clark
    May 11th, 2008 at 21:39 | #11

    Private currency anyone?

  12. Ernestine Gross
    May 12th, 2008 at 09:49 | #12

    Re 11:
    Joseph Clark “Private currency anyone anyone”

    Frequent flyer points aren’t doing very well, are they?

  13. conrad
    May 12th, 2008 at 10:31 | #13

    charles,

    I’ve worked in China before. That’s why it is blatently obvious to me (and I presume anyone else that has worked there) that Chinese money spent in China would be better than Chinese money spent on US treasuries etc. In one case you are helping people with nothing, in the other you are helping people drive around in SUVs and other essentially useless things.

  14. May 12th, 2008 at 12:08 | #14

    Conrad,
    Exactly. That is not, however, the position of the Chinese government.

  15. smiths
    May 12th, 2008 at 13:56 | #15

    all of the alternatives you have mentioned john are fiat currencies, and all are in the same provess of being inflated,
    maybe something like gold might be the reserve for a while as the wave of fiat defaults cascade across the financial system and temporarily destroy peoples faith in paper as money

  16. May 12th, 2008 at 18:23 | #16

    smiths,
    Spoken like a true Rothbardian. In reality, though, the days of huge inflation in any major currency are (I hope) over. Governments have generally learned that inflation is no longer popular as most people have worked out that inflation generally only acts to transfer wealth from the poor to the rich.

  17. smiths
    May 13th, 2008 at 10:55 | #17

    andrew i am not adherent to any school or individual, i read as much as i can and compare it it to the best and widest information i can,

    why is the value of the us dollar declining in your opinion, and why concurrently has gold gained in inverse proportion (roughly)

  18. smiths
    May 13th, 2008 at 11:03 | #18

    andrew please view this graph, and explain to me how this is not inflation of the fiat US currency and debt as denominated in said US currency,

    because if my understanding is wrong then i would genuinely like to know why and correct it sooner rather than later

    http://bigpicture.typepad.com/photos/uncategorized/2007/12/21/money_supply.png

  19. Ian Gould
    May 13th, 2008 at 12:40 | #19

    Smiths, the US dollar is declining in value for the simplest reason possible – supply exceeds demand as the US Fed is flooding the monetary system with excess liquidity.

    The US dollar isn’t just falling against gold, it’s falling against virtually every currency and commodity on the planet.

  20. smiths
    May 13th, 2008 at 13:22 | #20

    ian that is exactly what i was saying, andrew called me a rothbardian and said

    the days of huge inflation in any major currency are (I hope) over

    hence my question as to why he personally thinks the dollar is declining

  21. Ernestine Gross
    May 13th, 2008 at 13:26 | #21

    Ian, wouldn’t it be fair to say that in addition to the US government deficit (demand for dollars to finance the war and whatever else) the private sector (private sector credit creation) added to the demand for US currency and the US Fed provided what you call ‘excess liqudity’ to prevent a financial systems collapse?

  22. smiths
    May 13th, 2008 at 13:57 | #22

    well i would say ernestine that they have tried to do that,
    but by trying to prevent the inevitable they have only postponed it and it will be even worse as a result

  23. Ernestine Gross
    May 13th, 2008 at 14:07 | #23

    smiths, there is nothing inevitable except death.

  24. Ernestine Gross
    May 13th, 2008 at 14:18 | #24

    I suppose the term ‘Post American World’ is meaningful if one starts from the premise that there was an ‘American World’ at one point in time. I am not aware that an ‘American World’ ever existed outside the U.S.A. I’ve a related issue with the term ‘globalisaton’ – to the best of my knowledge there was no need to ‘globalise’ the world because it was ‘globalised’. If people want to say something else with the term ‘globalisation’ then they may as well spell it out.

    As to the US dollar being a reserve currency: It used to be a reserve currency for many countries (ie their central banks) outside the so-called Sowiet block and China. Charles de Gaulle stopped the US dollar being a credible reserve currency in the early 1970s when he asked for payment in gold (smiths, this sentence does not imply that I am arguing in support of a ‘gold standard’ or some version thereof).

    The question is, I suppose, who needs a reserve currency and under which conditions. JQ has made the distinction between floating and pegged currencies. I have nothing to add on this point.

    A lot of international trade is carried out by multinational corporations. It is known for quite some time that, beside using transfer pricing, these organisations are able to carry out a lot of international trade in a multiple bi-lateral fashion. That is to say, their problem is (rather like that of a tourist) to have enough of currency number x to cover purchases in currency x. One way to achieve this for a multinational corporation (but not for a tourist) is to use revenue in currency x. The total requirement for foreign exchange transactions can hence be reduced and methods, as described by Andrew Reynolds, are available.

    This leaves, IMO, ‘risk management’ on an aggregate level. That is, IMO, JQ’s article on the role of government in risk management becomes relevant. I am not convinced that governments of countries with a floating exchange rate require a ‘reserve currency’ for that purpose. It seems to me the crucial problem at present is to deal with the essentially unboundedness of an economy with private credit creation in all convertible currencies.

  25. smiths
    May 13th, 2008 at 14:25 | #25

    thats not really true erni,
    the effects of gravity are inevitable
    and then you will say, “not in space”
    but we dont live in space,

    i was searching for fiat currencies that lasted longer than a hundred years… not many

    The only proper use for paper, in the room of money, is to write promissory notes and obligations of payment in specie upon.
    A piece of paper, thus written and signed, is worth the sum it is given for, if the person who gives it is able to pay it, because in this case, the law will oblige him. But if he is worth nothing, the paper note is worth nothing.
    The value, therefore, of such a note, is not in the note itself, for that is but paper and promise, but in the man who is obliged to
    redeem it with gold or silver.

    Thomas Paine

    My arguement is that the collpase is inevitable because they cannot honour their promisory notes,
    it is a crisis of solvency not liquidity,
    and default is not only possible but increasingly likely since they cannot print their way out of the shit

  26. observa
    May 13th, 2008 at 16:22 | #26

    Don’t worry, Standard and Poors are on the job-
    http://www.atimes.com/atimes/Global_Economy/JE13Dj06.html
    while we doomsayers are busy extending and stocking our bunkers. In the building game ‘How much for cash?’ no longer cuts much ice around here. I’m strictly a commodities man these days.

  27. Ian Gould
    May 13th, 2008 at 23:55 | #27

    “Ian, wouldn’t it be fair to say that in addition to the US government deficit (demand for dollars to finance the war and whatever else) the private sector (private sector credit creation) added to the demand for US currency and the US Fed provided what you call ‘excess liqudity’ to prevent a financial systems collapse?” – Ernestine

    Well first up, when a big chunk of government spending is financed by foreign lenders, higher government spending can actually lead to higher private sector spending via bigger government payrolls and higher corporate profits.

    But that aside, I agree that US private borrowing has been excessive – and probably relates in part to the mystifying willingness of foreign governments to take massive capital losses on their lending to the US government. This has allowed the US to keep interest rates low despite the dual deficits.

    I agree that some support was needed to prevent a systemic failure but I think the Fed has gone too far. The massive lowering of US interest rates has probably reached the point where it is actively harmful due to its impact on inflation and the dollar.

    Real US interest rates are probably in the region of -2.5% now – assuming nominal official rates of around 2.5% and inflation running at 4.5% or higher.

    I think that’s close to or above the highest negative real rate of interest seen in Japan in the 1990s.

    Japanese attempts at reflation, you’ll recall failed miserably in terms of restoring economic growth and saddled the Japanese government with huge public debt.

  28. Ernestine Gross
    May 14th, 2008 at 12:31 | #28

    Re #25 and its predecessors.

    No, smiths, your guess about what I (assuming ‘erni’ is meant to read ‘Ernestine’) would say in reply to your reply in item #25 is not correct.

    In # 22 you use the word ‘inevitable’ in an economic context. In #25 you use the same word in a natural science context. I would suggest that this is a problem. Historical observations in economics do not have the same quality as in natural science because humans can change the institutional (legal) environment – the rules of the game.

    You give an example of insolvency being the result of private credit creation (default on promissory notes denominated in currency issued by a monetary authority). I concur, given the current institutional environment, but not under all conceivable institutional environments and not even under all historical institutional environments. Suppose the laws are changed such that private credit creation is ‘outlawed’. An instance of ‘insolvency’ (keeping the meaning of the word constant) would then constitute an instance of a criminal act – true? (I am not advocating such a law – I am using an extreme example to make a point.) Clearly, a criminal act is independent of fiat versus commodity money or some version of a ‘gold standard’.

  29. Ernestine Gross
    May 14th, 2008 at 13:04 | #29

    Re # 27. Thanks, Ian, for your reply. Just a few words in response.

    Yes, government expenditure financed by foreign lenders can be associated with higher private sector spending (ie disposable income is higher due to lower taxes than what they would have to be without foreigners buying debt securities issued by the government). However, this possibility does not ensure that therefore the sale of privately issued debt securities remains unchanged or is reduced. Indeed, you say that US private borrowing has been “excessive�. So, the whole US economy runs on credit governments and corporations and individuals – something which US economists and commentators mention more frequently.

    You may well be right in saying that the Fed has gone too far. I have no opinion on this question – I don’t have the information and the analytical support the Fed has. But I maintain and defend the last sentence of my predecessor post: “It seems to me the crucial problem at present is to deal with the essentially unboundedness of an economy with credit creation in all convertible currencies.� I am saying that financial stability requires quantitative constraints on the issuance of debt securities, both their type and the total nominal amounts. The capital adequancy framework is too indirect (ratios of categories within an accounting framework).

  30. smiths
    May 14th, 2008 at 13:25 | #30

    ok ernestine, fair enough, nothing in economics is inevitable,

    anyway,

    bloomberg is reporting that the British Bankers’ Association is considering changing the way it sets the London interbank offered rate.
    The association is under pressure to show the rates are reliable following complaints by investors that financial institutions weren’t telling the truth…

    and here are some thoughts from equity strategist Albert Edwards at Societe General

    “Even as structural bears on equities over the last decade, we have never felt the confidence to lower equities to a minimum possible exposure of 30%. That ends today,” he wrote.

    “It is the first time in over a decade that we have felt so very strongly that we make this recommendation. Conversely, as the world frets about inflation we raise our government bond weighting to its maximum 50%. We are not through the worst of this crisis. The worst is still to come.”

    “We are trying to give our readers the strongest possible warning (ever!) that we are on the cusp of an equity meltdown that will slash and shred portfolios like Freddie Krueger. We see a global recession unfolding. Nowhere and nothing will be immune.”

  31. May 14th, 2008 at 14:06 | #31

    smiths,
    And one must always bow to the banks. They get it right every time.
    LOL.

  32. Will
    May 14th, 2008 at 17:21 | #32

    Smiths, the investors who most rely on Libor, and are most impacted by understatement of Libor, are the commercial banks who use it as a common proxy for their cost of funds (base rate) in setting interest rates on syndicated floating rate loans. We’ve known about the understatement of Libor for quite a while and have been building the additional cost of funds into the margin over base rate on new loans that we underwrite. In any event, Libor never reflected each banks’ actual cost of funds, and there are plenty of lowly rated banks in the market who have never been able to fund at Libor. It is simply an index and, like all things in finance, those who use/rely on it have to understand it, and generally the banks do. I guess I’m saying that the Libor thing is not the end of the world or any real indication of it, nor is it any real indication of dishonesty or misleading of investors, despite a lot of headlines in the press in the UK.

    I would also be interested in how an equity strategist comes up with their ideas? Anyone can make a prediction, and his may even turn out to be right, but is there any actual science behind it? If so I’d be very interested in finding out what it is. Otherwise its just punditry, and being an “equity strategist” doesn’t make you any better a pundit.

  33. smiths
    May 16th, 2008 at 13:30 | #33

    In reality, though, the days of huge inflation in any major currency are (I hope) over. AR

    The central bank also reported that the M2 measure of money supply rose by $1.1 billion in the week ended May 5. That left M2 growing at an annual rate of 6.7 percent for the past 52 weeks, above the target of 5 percent the Fed once set for maximum growth. The Fed no longer has a formal target.

    The Fed reports two measures of the money supply each week. M1 includes all currency held by consumers and companies for spending, money held in checking accounts and travelers checks. M2, the more widely followed, adds savings and private holdings in money market mutual funds.

    During the latest reporting week, M1 fell by $7 billion. Over the past 52 weeks, M1 declined 0.1 percent. The Fed no longer publishes figures for M3.

  34. May 16th, 2008 at 14:23 | #34

    smiths,
    For the simple reason that the monetarist’s dream of trying to control inflation by holding the growth in (insert choice of monetary measure to be used) has proved elusive. How do you define the money supply, smiths? M1, M2, M3 Broad money or any one of the others? All of them move in differing ways – as you indicated. Each would have a different policy result.
    You are looking more Rothbardian every time you comment.

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