Over the fold is my article in today’s Fin, drawing on a blog post from a while back. Thanks to everyone who contributed to the discussion
The news that the Australian dollar has once again approached parity with its US counterpart has been attributed to the strength of commodity prices and to expectations of higher interest rates. But, whatever might explain the latest news, the real story is not the rise of the $A but the decline of the $US.
In fact, measured against the euro, the Australian dollar has traded in a narrow band, from 56 to 66 euro cents ever since the currency was introduced in 1990. And until the recent decline associated with the financial crisis originating in US mortgage markets, the British pound displayed similar stability against the Australian dollar and euro.
Contrast this with the US dollar, which has halved in value from an all-time high of $A2.12 to its current value of $A1.04 in just seven years. This is the reverse of the usual way of quoting things, but it is more relevant in many ways. The convention of quoting exchange rates and commodity prices, such as the price of oil, in US dollars is one outcome of a global financial system in which the US dollar acts as the reserve currency.
The decline of the US dollar, and the trends that have contributed to that decline, raise real questions as to whether the dollar can continue to play the role of a reserve currency.
On the standard textbook account, money serves three main purposes. It is a medium of exchange, a store of value and a unit of account. In the international context, a reserve currency plays the same role.
It is as a store of value that the US dollar is proving unsatisfactory. Although currency values have fluctuated ever since the breakdown of the Bretton Woods system, the decline of the dollar appears likely to be sustained.
Even after steep depreciations against most currencies with market-determined exchange rates, and smaller, but still significant depreciations against managed currencies like the Chinese yuan, the US is still running a large trade deficit.
US inflation rates are higher than those of most of its major trading partners. Moreover, the US Federal Reserve has shown a much higher tolerance for inflation than other central banks. By focusing on measures of inflation that exclude energy prices, it has taken a bet that increased commodity prices will not feed into broader inflation. As a result, the the Federal Funds rate has been cut to 2 per cent (a negative real rate) at the same time as interest rates have risen elsewhere..
Finally, the crisis originating in the US subprime market casts doubt on the assumption that US financial assets represent a safe haven for investors concerned about financial instability. The downgrading of large numbers of AAA rated assets to junk status, and the rash of defaults that has followed must cast doubt on the safety of investments presented as virtually risk-free.
But if the $US no longer meets the requirements of a reserve currency, what can replace it, and how will this change come about? And does the concept of a reserve currency make sense any longer?
The obvious alternative to the $US is the euro. At current exchange rates, 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)
One possibility 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.
Thus far, the eurozone authorities have shown no interest in such a development. Suggestions that Iceland might adopt the euro without joining the EU have received an appropriately chilly response from the European Central Bank.
Another alternative to a dollar-based financial system would be based on a basket of leading currencies, the most obvious candidate being the IMF Special Drawing Right. However, a shift of this kind would require the explicit consent of the US, and therefore seems unlikely.
So, the most likely outcome is that the reserve currency role of the US dollar will be eroded over the next decade or so, but that no single alternative will emerge for some time. The absence of a generally accepted reserve currency will make for interesting times.
John Quiggin is an ARC Federation Fellow in Economics and Political Science at the University of Queensland.
John Quiggin 
Another nice piece in public education.
Makes you wonder what we could all use. Umm.. salt, cowrie shells, frankinsense, myrrh… nope, too hard…I give up!
Might be an excellent example of ‘Physician heal thyself’-
http://www.news.com.au/story/0,10117,23967081-401,00.html?from=public_rss
“But, whatever might explain the latest news, the real story is not the rise of the $A but the decline of the $US.
“In fact, measured against the euro, the Australian dollar has traded in a narrow band, from 56 to 66 euro cents ever since the currency was introduced in 1990. And until the recent decline associated with the financial crisis originating in US mortgage markets, the British pound displayed similar stability against the Australian dollar and euro.”
I can’t remember if I’ve mentioned this before, but there is a special sort of graph that can highlight this sort of thing. Suppose some event happens and you only have (say) the US$:AUS$ rate to look at; it will move, but you don’t know which “end” has the event. Two exchange rates tell you better, though of course they don’t tell you when multiple events show up or an event acts systemically. With arbitrage, three rates – between the US$, AUS$ and pound, say – give you two independent numbers, with all the ratios going round a cycle multiplying to unity. So, you can plot currency movements on a graph represented by an equilateral triangle, with a point’s distance from each side representing the logarithm of one rate (maybe plus a constant), since geometry makes these add to a constant. The point’s movement will highlight how different events are localised by country, or how their effects fall differentially – always remembering that systemic stuff won’t show.
This kind of graph helps a lot in some other areas, e.g. the effects of third parties under a first past the post system. It clarifies an odd effect in the UK in earlier decades, how a swing to Liberal gave Labour more seats even though it lost overall support; the cloud of points representing constituencies was so shaped that, with a typical loss of Conservative support about three times that for Labour, more constituencies drifted slantwise from the Conservative zone to Labour (without coming out the other side to Liberal, though heading that way) than moved from Labour to Liberal. The graph also shows how a cumulative voting system would give a pattern of seats closer to underlying support.
That’s how it goes-roll the printing presses-finally the players wake up to the Ponzi scheme and try to turn it into commodity money- that lets the inflation genie out of the bottle- then holders of money need real returns to wean them off commodities- that means central bankers have nothing to do but spectate for their large salaries
‘ST George Bank has lifted its standard variable home loan rate by 20 basis points to 9.67 per cent, independently of the central bank.
Australia’s fifth largest bank attributed the rise to the continuing high cost of funds it sources for itself.
The rate rise equates to an increase of $10 a week for repayments on an average loan of $250,000 over 30 years.
St George chief financial officer Michael Cameron said all the banks had been absorbing a significant increase in funding costs.
The price of money has risen due to the impact of the US sub-prime lending crisis on global liquidity and wholesale funding markets since August last year.
“While we have already completed our wholesale funding requirements for this financial year, the spread between cash rates and 90 day rates in particular remains significantly higher for the industry than a year ago,” he said.
St George group executive retail bank Les Matheson said that even after today’s rate hike, the lender would not be “fully recovering all of our increased funding costs for this financial year”.
“St George maintains its commitment that if funding costs were to reduce for a sustained period of time, we would then look to adjust our rates.”
The Reserve Bank left official interest rates unchanged at a 12-year high of 7.25 per cent this week.
It had raised rates in February and March, prompting moves by the major banks to match those increases, while adding more hikes of their own.
The ANZ’s standard variable rate is 9.47 per cent, the Commonwealth Bank of Australia’s rate is 9.44 per cent, Westpac’s rate is 9.47 per cent and the National Australia Bank’s is 9.46 per cent.
St George has also increased a range of special deposit rates by an average of 50 basis points.’
Have a listen to this lot for a laugh-
‘A WEAKER US dollar cannot be blamed for soaring oil prices as policymakers around the world tussle with the twin specters of rising inflation and slowing growth, US Treasury Secretary Henry Paulson said overnight.
Some of the world’s leading oil producers and market analysts say the weak US dollar is a key factor spurring many dollar-denominated commodities — including oil — to record highs, pushing the cost of living higher across the world.
It is rare for the US government to say anything about the greenback beyond its mantra that it believes in a strong dollar, but developed nations are ramping up the rhetoric in an effort to get oil producers to increase supply and help tame inflation.
“The dollar has had a very small impact,” Mr Paulson told reporters in London, after a meeting with top British bankers and British finance minister Alistair Darling.
“Take a look, the dollar has depreciated roughly 24, a little bit less than 25 per cent, since February 2002. Oil has gone up well over 500 per cent. It’s gone up in every currency.”
The greenback is currently languishing near record lows against the euro after a run of aggressive interest rate cuts from the US Federal Reserve and worries over US economic growth.
Oil prices hit a fresh record high above $US145 a barrel overnight. Prices have doubled in the past year.
Inflation has now taken top billing in most central bankers’ deliberations, with markets expecting higher borrowing costs despite sharply slowing growth in Europe and the United States.
Central bankers in Europe have said one factor also helping to boost commodity prices skywards is the policy of fast-developing economies in the Asia and the Middle East of pegging their currencies to the dollar.
Those pegs have triggered a more expansionary monetary policy than might be necessary — as falling interest rates in the United States have been mirrored to track a weaker US dollar — helping to spur growth and consequently demand for commodities.
Mr Paulson said, however, that market fundamentals were to blame.
“I believe that although there may be a number of factors with regard to oil, the predominant factor by far is supply and demand, is the fact that global production and capacity hasn’t increased appreciably over the last 10 years and the demand has continued to grow and inventories are at low levels,” he said.
“Only if you acknowledge the issue are we going to be able to deal effectively with finding a solution.”‘
That’s about as close to an admission of guilt as we’re ever going to get from them all. A sorry might be nice chaps if you were really sincere.
Notice the related issue here, that if you are a total skeptic that you could ever trust a global C&T, quantity control, grand plan to these sorts of expert Keynesian minds, then you’re obviously delusional. Yeah, riiiiiiight!
When their new vision splendid goes equally pear shaped they’ll no doubt exclaim ‘however, that market fundamentals were to blame’. Either that or blame those nasty ultimate Asian Keynesians, which is no doubt why they want to leave them out of their new grand plan. Always learning from bitter experience. You know it makes sense!
Pr Q says:
You would have to predict that US inflation will rise as the higher price of oil feeds into their carbon-dependent economy. When this happens there will be increased pressure on US currency and security markets. Think bear on bonds, stocks and bucks. (Not to mention bricks!)
The key variable is US interest rates which are well out whack with comparable countries. Obviously one suspects presidential political interference here, both to protect asset holders wealth and to dampen a recession-driven GOP wipeout at the 2008 elections.
No doubt Bush will try and delay the day of reckoning for as long as possible. He does that in everything, from climate change mitigation, to Iraq withdrawal to sovereign debt amortisation.
I looked up the US interest rate the other day just to check on an aspect of the yen carry trade. I was shocked to discover that the rate was down to 2%.
The official US inflation rate is ~4%. Its not clear if this rate is properly registering commodity price inflation. If not then US real US interest rates are in the region of -3%.
Negative real interest rates are not unheard of, think Japan in the nineties. This does not bode well for US monetary policy efficacy. Its already “pushing on a string” with a vengenance and the economy is not even properly in recession.
They also encourage commodity price speculation. Borrow skads of cheap US money and go long on oil price futures. Sounds suspiciously familiar, dont it?
However this kind of play is just as unsustainable as the credit binge that underlies it. Eventually financial chickens come home to roost.
Poor old Barry O’Bama. He will be the mug who has to clean up this mess. A poison pill that will probably intoxicate any political efforts to mitigate climate change.