After the dollar

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

34 thoughts on “After the dollar

  1. “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.

  2. 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’.

  3. 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).

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


    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.”

  5. 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.

  6. 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.

  7. 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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