Without changes to reserve currencies another crisis is inevitable
We saw that Joseph Stiglitz proposes a new reserve currency to alleviate pressure on trade imbalances. Michael Pettis is now also proposing a similar move away from the U.S. dollar. In an FT Op-Ed, Michael wrote that every generation we hear warnings that the dollar’s dominance will wane. In his view, these warnings have intensified of late. The reality is that the US dollar’s reserve currency status is a ‘public good that comes with a cost’. And the cost is debt accumulation in net importing countries along with trade imbalances that becoming a lightening rod for economic nationalism and protectionism. He recommends the US take the lead in moving to a multi-currency world. I support this recommendation and believe that another crisis is inevitable if we do not move in this direction.
As Michael wrote me, it’s funny that if you are ‘pro-US’, you argue for continued dollar dominance. And if you are ‘anti-US’ you call for the end of the dollar reserve standard; it should be almost the opposite.
Let’s step back a minute, though. In actual fact, if you think about free trade, cheaper and better imports are the benefit of free trade, exports are the cost. The exports and the labour sacrificed from domestic production for export is what a nation gives up to get the better and cheaper goods that trade makes available. George Mason’s Economics Chair Don Boudreaux put this well four years ago, writing:
the ultimate benefit of trade lies not in what people must sacrifice-not in the creation of opportunities to produce output for others-but in the greater quantity, quality and variety of goods and services that free trade makes possible for ordinary people to consume. Free trade’s bountiful harvest is not its exports; it is its imports.
That is the correct way to think about trade. This ‘import benefit’ is the theoretical underpinning of free trade.
Nevertheless, as it stands today, large trade imbalances have opened up in the global economy that are creating friction. First and foremost, there is the debt problem. Globalization, trade, and America’s reserve currency status are not blameless. As the manufacture of goods has shifted abroad, many Americans have lost their jobs only to find jobs of considerably less pay. Others have found their manufacturing jobs pay less as their employers have filed for bankruptcy. The events with GM and Chrysler are the most memorable example.
To mask the decline in median wages, starting with Alan Greenspan, American policy makers have turned to an asymmetric monetary policy that fosters the accumulation of debt. Americans have reduced savings and accumulated debt. (See this chart from just before the crisis on household debt versus personal savings). If you know your accounting identities, you know that the real twin deficits in America are the savings deficit creating the trade deficit (not the government deficit creating the trade deficit as some ideologues have postulated. Read Rob Parenteau’s analysis in this post on why stimulus is no panacea.) So in a very real sense, the trade imbalance in America is connected with debt accumulation, the financial crisis, the resultant deleveraging and today’s poor economy.
Moreover, as Pettis writes, "foreign acquisition of dollars automatically forces the US into running a corresponding current account deficit." So there is a trade deficit built in to the dollar’s reserve currency status that is only exacerbated by the asset-based economic model in the US that favours the accumulation of debt, low savings, and, therefore, even larger trade imbalances.
When times are tough, people start looking for someone to blame. This is a universal truth. And usually it is not the In-group which gets the blame but out-groups like minorities, immigrants and foreigners.
So, what invariably happens – as we saw in the 1930s, large trade imbalances become a flashpoint during periods of economic weakness. Nationalism takes over as ‘out-groups’ are blamed for the economic trouble. Protectionism and trade conflict, then, are inevitable unless policy makers find a way to revive the economy.
These flashpoints are inevitable because the dollar standard is flawed because of the excess credit creation we see in the fiat currency system. Going back to the Triffin Dilemma, the source of this conflict in having a national currency as a reserve currency, leading to trade deficits, I wrote the following in January of last year:
During the Bretton-Woods era, this problem was manifest in the continual loss of gold reserves in the U.S. since the tether to gold had not been completely broken. But, eventually the U.S. had to drop its peg to gold in 1971 as the pressure became too much to bear.
In the post-1971 period, as emerging economies have grown and developed economies expanded credit, the U.S. has been forced to satisfy global claims for U.S. dollars. This has induced an even larger deficit because there has been no check on balance of payment imbalances without the gold anchor. These imbalances are unsustainable as it puts the U.S. in a situation in which U.S. dollar denominated public and private credit claims cannot be settled with the current dollars outstanding. Either more and more U.S. dollar net financial assets have to be manufactured or the dynamics of debt deflation will kick in.
In plain English: the reason credit has surged dramatically over the last generation has much to do with the monetary system; unless we successfully reflate asset prices, the claims on dollar-based assets cannot be met under this jury-rigged monetary system with the U.S. dollar at the core. I see this as a Ponzi scheme which is now in its final chapter.
There are two exit strategies from this.
- Manufacturing more U.S. denominated financial assets. Implicitly, this is the strategy we are now following. The goal is to limit the currency depreciation through the additions from the real economy value which ostensibly underpins these new net financial assets. Obviously, if you think spending more money is likely to misallocate resources, as I do, you aren’t going to like this approach.
- Maintain existing money stock despite the credit claims. Debt that cannot be repaid, won’t be repaid. It’s as simple as that. The problem here, of course, is that this is deflationary. Yes, it rewards savers by not diluting their assets, but there is the real threat of a deflationary spiral and geopolitical tension as a result.
Both of these solutions have major problems. The first solution is a form of Ponzi finance in my view. It’s kicking the can down the road as it leads to debt deflation eventually anyway – unless you want to go the Weimar or Zimbabwe route. The second is deflationary and puts acute stress on economies with high levels of indebtedness due to debt deflation and resulting social unrest that accompanies it.
Ultimately, I hope this highlights the untenable nature of current currency system, because that is what is at the heart of the problem. From a U.S. perspective, a diminished reserve currency role will actually help alleviate much of the problem.
To my mind, this makes a very strong case for ending the dollar standard. This age of fiat currencies will end badly if remedies are not taken. Christopher Wood put it well in March of last year:
My view is that there is an inevitable endgame as a result of all this massive spending of taxpayer money in the West and Japan to bail out bankrupt banking systems, so in my view unfortunately the end game will be systemic government debt crisis in the western world.
It will probably happen in Europe and will climax in the US, and I am expecting on a five year view the collapse of the US Dollar paper standard…
The key reason why that’s the endgame is that this credit crisis we saw in the west in 2008 and 2009 has simply been deferred, because 95% of the so-called government policy solutions to deal with this crisis have simply been to extend government guarantees.
So the problem’s been transferred from the private sector to the public sector. It’s just a matter of time before investors revolt against these sovereign guarantees … The crisis is going to happen first in Europe. It’s going to climax in the U.S.