Dale Franks has been doing a bit of economics blogging and he has some significant concerns about the economy. I do as well and they roughly mirror his own.
One of the areas of concern that some people have is the threat of depreciation of the dollar due to the large size of our current account deficit. The theory being that eventually countries, especially China, will diversify away from the dollar and lead to a repatriation of dollar assets. That means rising interest rates and inflation as well as a slowdown or outright recession as our economy adjusts to buying less from abroad and exporting more. That is likely to happen to some extent.
The worst case scenario is that the we would cease to be the worlds reserve currency. In essence the dollar (or financial assets such as bonds and stocks denominated in dollars) has replaced gold as the asset which backs the worlds currencies.
To understand the situation imagine if all the worlds gold was produced here in the US and was the asset other countries banks used to back their currencies. In essence a gold standard with the US being the sole supplier of gold. We literally could export money (gold) in return for goods and services. Not a bad deal. Well, that is what we do now, we just use dollars instead of gold and it is a sweet deal. The reason people trust other currencies to have value is that the currency is backed by a portfolio of US currency, stocks and bonds which theoretically can be exchanged as needed for the local currency. So what we do here in the US is buy goods from other countries (I’ll use China as an example) and the Chinese exporter takes our dollars and exchanges them for Chinese currency. The central bank keeps a good bit of those dollars and thus demand for dollars is not fully met, thus propping up the value of the dollar versus the Chinese currency. More demand versus reduced supply leads to a higher price for the dollar than otherwise would exist. This means the Chinese run a trade surplus with us. As long as the Chinese accumulate dollar assets the trade deficit we run cannot be eliminated.
So what do the Chinese get? We gain in an obvious way. We in essence export money in exchange for goods. Most countries have to export services and goods in exchange for goods and services. We don’t have to to a certain extent, which is a wonderful situation. The Chinese get a currency people feel can be exchanged for dollars which they know can be exchanged anywhere, because it is other governments primary reserve as well. Of course idle currency is a pretty poor store of long term value, so the government exchanges that for bonds and other assets which back their currency and is what people are referring to when they say we are in debt. I think that is a poor way to look at it, because the term debt implies that what they have bought hasn’t evened out the exchange, but I’ll avoid that complication for now. The practical effect of this debt is that they can at some time in the future take those assets and spend them here on goods and services, which is exactly what people concerned about the trade deficit want them to do, they just want them to start sooner rather than later. My own opinion is they have spent it here, they sent us goods, we sent them money and bonds which are a pre-requisite for their currency to have any value. That is a pretty valuable service for them, and one we don’t need. We don’t need to run a surplus, they do.
So what is the worst fear? That the rest of the world will stop using the dollar as a reserve currency. Now this may seem to be odd, since the critics of running a trade deficit want us to do something about it (usually some form of protectionism) you would think the trade deficit hawks would welcome the Chinese or others suddenly deciding to spend the money here rather than using it to back their currencies. Over time we would have to run surpluses which we are told are wonderful things, rather than necessary evils because people generally want something when we sell them something. Other countries have to actually export the fruit of their labor, we export our money, which is in fact exporting faith in us.
In this case the critics are right, even if many are inconsistent in their logic in getting there. Surpluses are terrible things to have to run and a sudden shift to in essence honor every other countries sudden demand for actual goods and services would be a pretty terrible thing to have to do. We would all have jobs, but we would be sending the product overseas in exchange for our money, which nobody else would want because they are getting rid of all the money they have been accumulating these many years. That means more money chasing fewer goods and services still left at home. The result being inflation and falling living standards. The key point is if you have fewer goods to divide amongst us to consume then we have a lower living standard. Inflation and a lower dollar is just how that fact would manifest itself.
Dale gives many of the reasons why the world wouldn’t suddenly decide to dump all of their dollars in this post. I however would like to suggest something more basic. The rest of the world doesn’t want another currency as a reserve currency. Reserve currencies are very difficult to replace. Nothing else out there will work. Why? For that I will steal from the always interesting guys and gals at Gavekal:
Attribute #1: “The issuing country must be dominant militarily. And here the logic is simple: One holds a reserve currency for random crisis events. Wars are random crisis events. One wants to ensure that, in case of a war, one is able to buy the best possible weapons… and be sure that the weapons will be delivered.”
Attribute #2: “The issuing country must be dominant technologically (see above).”
Attribute #3: “The issuing country must be dominant agriculturally so that in case of a random crisis, reserves can be morphed into food to feed local populations.”
Attribute #4: “The issuing country must be mature financially (i.e., have developed financial markets) so that in a random crisis, the afflicted country has the ability to raise money in the financial markets.”
Holding Euro’s or Yen as the primary reserve currency doesn’t make sense in any of the crises that a country might face. This doesn’t apply just to (once again for example) the Chinese. It has to be true for whoever they wish to buy from in a crises. In a real crises when you need to buy from someone they will want something they can count on, the dollar.
So let us take those attributes one at a time:
“The issuing country must be dominant militarily. And here the logic is simple: One holds a reserve currency for random crisis events. Wars are random crisis events. One wants to ensure that, in case of a war, one is able to buy the best possible weapons… and be sure that the weapons will be delivered.”
If there is a war and you need to buy weapons what good are Yen going to do you? The Japanese won’t be able to deliver any weapons you buy while the US has the Seventh Fleet to make sure the sea lanes stay open. This obviously is less important to the Chinese, though not irrelevant, but it is very important to those they might buy from who are more or less our allies. This is also a great peacekeeping benefit. China is very dependent on the US, not the other way around. Self interest means trying to make sure the US isn’t on the other side.
“The issuing country must be dominant technologically (see above).”
No point in a crisis having a basket of third world currencies. They don’t have what you need.
“The issuing country must be dominant agriculturally so that in case of
a random crisis, reserves can be morphed into food to feed local
populations.”
Only a few countries have the ability to ship (and deliver) massive amounts of aid, especially food. We can.
“The issuing country must be mature financially (i.e., have developed
financial markets) so that in a random crisis, the afflicted country
has the ability to raise money in the financial markets.”
All that money needs to be able to be absorbed. Our economy is large enough and has capital markets deep enough to be of use in a crisis. Who else does at this point? If you look at all four attributes no other country fits all of them.
The fifth element is the institutional barrier to change. Anywhere you go people will take dollars, changing that sense of security and trust to something else will be a tall order. This is in essence a network effect built on universal acceptance.
Connected to the size and depth of our economy and capital markets and the fact that we are a reserve currency, is the responsibility to provide global liquidity when necessary. America has shown it will do so. Will anybody else trust China or Japan (who blew that in their own country) to do that, to be the spender and lender of last resort? That responsibility is part of the cost of the enormous advantages we derive from being the reserve currency.
Given the costs of changing it is unlikely that the doomsday scenario of a rapid move from the dollar is in any way likely. The only alternative is gold, and that is unlikely to happen. Of course some will say our profligacy is destroying our fiscal house and we will soon no longer possess the attributes necessary to continue as the reserve currency. I am certainly no fan of our fiscal idiocy, but not because we will fall from grace any time soon. Our economy will be fine, though I expect the ride may be bumpy in the next few years. More importantly, all the major competitors to be the reserve currency not only fail to meet at least one of the elements on the list above, face the inertia of widespread acceptance and other network effects, but have a worse long term fiscal picture than we do.
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Good explanation, Lance. Some of it is sort of intuitive, but you lay out the underlying premises quite well here.
One thing that I’m unsure about, however, is why gold or even the Euro, isn’t a threat to the Dollar’s supremacy, if not now, in the near future. Your analysis regarding the dominance of the country issuing the currency surely doesn’t affect a gold standard, does it? And the Euro meets nearly all those criteria, certainly enough to be used as a backing currency, doesn’t it?
The Euro meets a couple of objectives. First of all the size of the economy works, but not as well as the US and why undergo transition costs to trade down?
Financial markets are deep and liquid, but still second fiddle for now, though US regulations are whittling that advantage away.
Dominant agriculturally. The Euro is not dominant, but still strong enough. Still second fiddle though.
Military, this is the laugher. Story over.
The network effects are also key. Who wants to trade out of dollars to hold the euro? They are not accepted anywhere. You don’t have to exchange dollars, people just take them in much of the world. That is not true of the dollar. More importantly it will take decades for the Euro to be trusted as a unified currency. it is a common discussion if the euro will survive or at least have several countries withdraw. Nobody seriously talks about US states pulling out of the dollar in favor of their own currency. Even if it stays together, it does not represent a unitary state. Instead it represents a fractious bunch of states. Would you trust the Euro zone to back up any promises long term? Even if they had a military worth speaking of could it be relied on to be gathered to act in a unified manner?
Given all that, why change? It can’t be because the Euro zone is more fiscally responsible, they aren’t. At this point at most I can see a case for some diversification, which I expect to occur. That is no disaster and would probably result in a more stable financial system.