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.
An interesting Marxist perspective https://www.youtube.com/watch?v=qOP2V_np2c0
An interesting Marxist perspective https://www.youtube.com/watch?v=qOP2V_np2c0
I’m confused By Christopher Wood’s comments above. With a sovereign currency such as the dollar or Yen, I don’t see the public sector crisis. The US will not default on any debts as it can simply credit spreadsheets and the debt is paid. By growing the federal deficit, the private sector gets the dollars it needs to de-leverage. Where is the accounting problem with transferring private sector debts to the public sector?
Any MMT’er will tell you that the system is premised on the ability to tax and the use of the currency for that purpoose. If te government’s currency loses legitimacy, the system breaks down. The talk about crediting accounts is the typical MMT response to any question about sovereign debt. Sure, you can credit bank accounts ad infinitum. It does not address currency revulsion or inflation.
The reason commodity prices, gold and silver are increasing in price is because citizens are becoming increasingly uncomfortable with using fiat money. This is true in the US as well as in Europe. Clearly, we have seen a transfer of private debts onto the sovereign through this financial crisis. The U.S. federal debt load has increased 40% just because of the recession alone. I believe more and more people are beginning to flee fiat currencies. And when the next systemic crisis occurs, I believe we will see a breakdown in the system. That has nothing to do with the willingness or ability of sovereigns to credit bank accounts. It has nothing to do with accounting. It has everything to do with the citizenry’s comfort with their respective national currencies.
But then couldn’t the next systemic crisis be hyperinflation, aka a complete and utter loss of confidence in the dollar or its collapse? My concern over and over again is that there are a lot of USD out there, and in light of this BRICS conference, if it gets replaced as the world’s reserve currency, that means there will be a lot of US money floating out there, i.e., more $$s chasing fewer goods AKA huge inflation…
again, hyperinflation is a political event. you have to assume certain outcomes. it could happen as I stated in this post but it will only occur if the body politic desires this outcome. Read Miss.
I wrote:
“Basically Mises has laid out very concisely the fact that the business cycle is due to the extension and over-extension of credit. Trying to continue to expand credit eventually ends in a hyper-inflationary scenario as it did in Weimar Germany in 1923. As a result, most countries are forced to stop.”
At a minimum, you must assume that the Fed will not act to prevent inflation from continuing upward. You have to assume that the Congress will not act. Further, you have to assume that the relative price level in the U.S. detaches from its trading partners, meaning the US runs a monetary policy that is quite different from other CBs. It makes a good talking point for ideologues and it IS certainly possible but why would one make such an assumption?
It’s one thing to suggest that gold or silver could rise as currency revulsion steps in but it’s different to assume the monetary stewardship of the world’s reserve currency is markedly different from other countries.
I suggest you read Austrian devotee Brodsky and Quantaince’s post on QE3:
https://pro.creditwritedowns.com/2010/08/stabilizing-the-global-monetary-system.html
But do you really think the Fed is going to act to prevent inflation from going upward? With the unsustainable debt, it seems like hyperinflating it is the only option.
Sorry, but this is what keeps me up at night.
Also with regards to monetary policy similar to other CBs, aren’t the other CBs trying to raise rates to fight inflation? Bernanke doesn’t seem to be doing that.
I’m confused By Christopher Wood’s comments above. With a sovereign currency such as the dollar or Yen, I don’t see the public sector crisis. The US will not default on any debts as it can simply credit spreadsheets and the debt is paid. By growing the federal deficit, the private sector gets the dollars it needs to de-leverage. Where is the accounting problem with transferring private sector debts to the public sector?
Any MMT’er will tell you that the system is premised on the ability to tax and the use of the currency for that purpoose. If te government’s currency loses legitimacy, the system breaks down. The talk about crediting accounts is the typical MMT response to any question about sovereign debt. Sure, you can credit bank accounts ad infinitum. It does not address currency revulsion or inflation.
The reason commodity prices, gold and silver are increasing in price is because citizens are becoming increasingly uncomfortable with using fiat money. This is true in the US as well as in Europe. Clearly, we have seen a transfer of private debts onto the sovereign through this financial crisis. The U.S. federal debt load has increased 40% just because of the recession alone. I believe more and more people are beginning to flee fiat currencies. And when the next systemic crisis occurs, I believe we will see a breakdown in the system. That has nothing to do with the willingness or ability of sovereigns to credit bank accounts. It has nothing to do with accounting. It has everything to do with the citizenry’s comfort with their respective national currencies.
But then couldn’t the next systemic crisis be hyperinflation, aka a complete and utter loss of confidence in the dollar or its collapse? My concern over and over again is that there are a lot of USD out there, and in light of this BRICS conference, if it gets replaced as the world’s reserve currency, that means there will be a lot of US money floating out there, i.e., more $$s chasing fewer goods AKA huge inflation…
again, hyperinflation is a political event. you have to assume certain outcomes. it could happen as I stated in this post but it will only occur if the body politic desires this outcome.
Read Mises. “As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result”
Read more: https://pro.creditwritedowns.com/2008/12/what-does-mises-say-about-trying-to-stimulate-the-economy-out-of-recession.html#ixzz1JXtjaHRn
I wrote:
“Basically Mises has laid out very concisely the fact that the business cycle is due to the extension and over-extension of credit. Trying to continue to expand credit eventually ends in a hyper-inflationary scenario as it did in Weimar Germany in 1923. As a result, most countries are forced to stop.”
At a minimum, you must assume that the Fed will not act to prevent inflation from continuing upward. You have to assume that the Congress will not act. Further, you have to assume that the relative price level in the U.S. detaches from its trading partners, meaning the US runs a monetary policy that is quite different from other CBs. It makes a good talking point for ideologues and it IS certainly possible but why would one make such an assumption?
It’s one thing to suggest that gold or silver could rise as currency revulsion steps in but it’s different to assume the monetary stewardship of the world’s reserve currency is markedly different from other countries.
I suggest you read Austrian devotee Brodsky and Quantaince’s post on QE3:
https://pro.creditwritedowns.com/2010/08/stabilizing-the-global-monetary-system.html
But do you really think the Fed is going to act to prevent inflation from going upward? With the unsustainable debt, it seems like hyperinflating it is the only option.
Sorry, but this is what keeps me up at night.
Also with regards to monetary policy similar to other CBs, aren’t the other CBs trying to raise rates to fight inflation? Bernanke doesn’t seem to be doing that.
The legal tie to gold was fictional, the economic tie tenuous, & the protection was a myth.
The Bretton Woods Agreement of 1944 established, among other things, the International Monetary Fund and confirmed the previous international status of the dollar, that an ounce of gold was equal to $35 and that all dollars were to be freely convertible into gold bullion at that price to foreign and confirmed the previous international status of the dollar, that an ounce of gold was equal to $35 and that all dollars were to be freely convertible into gold bullion at that price to foreigners but not to U.S. nationals.
In 1949, the U.S. dollar was not only as “good as gold”, but it was also preferred over gold. There were not enough dollars to finance the legitimate needs of the world economy. So, the chronic balance of payments deficits which began in 1950 were for a number of years beneficial to the world economy and to the U.S. Because of our large and chronic balance of payments surpluses after World War II, foreigners were unable to accumulate sufficient dollar balances to efficiently finance world trade. These balances were desperately needed because of the total dominance of the dollar as the reserve custodian, standard of value and transactions currency of the world.
The Korean Conflict (1950-1953) temporarily solved the problem but, the longer term solution consisted in implementing our “containment policy” against the U.S.S.R. This involved the establishment of approximately 700 military bases, not only around the perimeter of the Soviet Union but throughout the world. We have paid hundreds of billions of dollars to foreigners to acquire the bases and to maintain a garrison of more than 400,000 military personnel abroad. With diminishing merchandise surpluses this policy proved to be financial overkill.
The Korean War, which began in June, 1950, initiated the chronic balance of payments deficits that persist to this time and which will probably continue as long as foreigners are willing to increase their net investments in this country.
The U.S. had a net liquidity deficit in every year since 1950 (with the exception of 1957), up to 1976 (when the private sector contributed its first trade deficit ). These deficits were entirely the consequence of excessive U.S. government (Pentagon) unilateral transfers to foreigners (re: foreign policy – solely our far flung military bases and personnel). During all this time the private sector was running a surplus in all accounts: merchandise, services and financial. The Vietnam Ten-year War administered the coup d’etat to our gold bullion standard. By 1968, in an effort to keep the dollar at the $35 par, we had exhausted nearly two thirds of our monetary gold stocks, or approximately 700 million ounces to about 260 million ounces.
The legal tie to gold was fictional, the economic tie tenuous, & the protection was a myth.
The Bretton Woods Agreement of 1944 established, among other things, the International Monetary Fund and confirmed the previous international status of the dollar, that an ounce of gold was equal to $35 and that all dollars were to be freely convertible into gold bullion at that price to foreigners but not to U.S. nationals.
In 1949, the U.S. dollar was not only as “good as gold”, but it was also preferred over gold. There were not enough dollars to finance the legitimate needs of the world economy. So, the chronic balance of payments deficits which began in 1950 were for a number of years beneficial to the world economy and to the U.S. Because of our large and chronic balance of payments surpluses after World War II, foreigners were unable to accumulate sufficient dollar balances to efficiently finance world trade. These balances were desperately needed because of the total dominance of the dollar as the reserve custodian, standard of value and transactions currency of the world.
The Korean Conflict (1950-1953) temporarily solved the problem but, the longer term solution consisted in implementing our “containment policy” against the U.S.S.R. This involved the establishment of approximately 700 military bases, not only around the perimeter of the Soviet Union but throughout the world. We have paid hundreds of billions of dollars to foreigners to acquire the bases and to maintain a garrison of more than 400,000 military personnel abroad. With diminishing merchandise surpluses this policy proved to be financial overkill.
The Korean War, which began in June, 1950, initiated the chronic balance of payments deficits that persist to this time and which will probably continue as long as foreigners are willing to increase their net investments in this country.
The U.S. had a net liquidity deficit in every year since 1950 (with the exception of 1957), up to 1976 (when the private sector contributed its first trade deficit ). These deficits were entirely the consequence of excessive U.S. government (Pentagon) unilateral transfers to foreigners (re: foreign policy – solely our far flung military bases and personnel). During all this time the private sector was running a surplus in all accounts: merchandise, services and financial. The Vietnam Ten-year War administered the coup d’etat to our gold bullion standard. By 1968, in an effort to keep the dollar at the $35 par, we had exhausted nearly two thirds of our monetary gold stocks, or approximately 700 million ounces to about 260 million ounces.
We can help terminate these deficits by (1) the U.S. government drastically reducing its overseas military expenditures – or by transferring most of the cost of maintaining bases and personnel to foreign governments; (2) revitalizing a large segment of U.S. industry so that it will be able to compete in foreign markets; (3) sharply reducing our dependence on foreign energy sources; and, (4) increasing the attractiveness of foreign long-term investment in the U.S.
Since actions sufficient to eliminate these deficits are highly improbable, the dollar will eventually decline to a level which will eliminate them. At that level our standard of living, for this and other reasons including financing the federal debt, will be much lower than at present, and the capacity of the Pentagon to project conventional military power abroad will be severely circumscribed.
Since the U.S. is no longer an economically undeveloped nation, but is increasingly an international debtor, what evaluation should be places on our huge trade and current account deficits? For the very short run these deficits keep prices and interest rates lower than they otherwise would be and they subsidize our standard of living. But the deficits also are inexorably forcing the dollar down in terms of its foreign exchange value—and no consortium of central bankers, treasury secretaries, et al. can stop the process
A weak currency is not a cause; rather it is a symptom of a weak, noncompetitive economy. In time, of course, a declining dollar will eliminate the deficit in our balance-of-trade. But the price exacted will be a sharp decline in imports, principally oil, and the purchase of foreign services, reflecting our relative poverty and inability to compete in the international economy. The fact that we are the world’s number one producer of smart bombs will not arrest that trend.
The problem is that further depreciation of the dollar will not correct our foreign trade deficit. In fact, further depreciation will only make our stocks and real estate even cheaper and even more attractive as a safe haven in this dangerous would. We are now currently selling our birthright for a mess of pottage. We are becoming a financial hostage to the Pacific Rim, their plantation if you will.
The volume of dollar-denominated liquid assets held by foreigners is extremely large. Any significant repatriation of these funds, by reducing the supply of loan-funds, will force interest rates up – thus increasing the federal deficit and the burden of all new debt. These events alone could trigger a downswing in the economy resulting in more unemployment, more unemployment compensations, less tax revenues and larger federal deficits — truly a vicious cycle.
Unfortunately, in this and other financial areas, expectations become reinforcing self-fulfilling prophecies. No country has become and remained a world power if it is a world debtor and has a weak currency. From these unwanted events we can expect a vicious level of stagflation that will become an enduring feature of our economic landscape. And the United States will be forced into a high degree of economic isolation, operate under a command economy — i.e., into an increasingly totalitarian mold.
We can help terminate these deficits by (1) the U.S. government drastically reducing its overseas military expenditures – or by transferring most of the cost of maintaining bases and personnel to foreign governments; (2) revitalizing a large segment of U.S. industry so that it will be able to compete in foreign markets; (3) sharply reducing our dependence on foreign energy sources; and, (4) increasing the attractiveness of foreign long-term investment in the U.S.
Since actions sufficient to eliminate these deficits are highly improbable, the dollar will eventually decline to a level which will eliminate them. At that level our standard of living, for this and other reasons including financing the federal debt, will be much lower than at present, and the capacity of the Pentagon to project conventional military power abroad will be severely circumscribed.
Since the U.S. is no longer an economically undeveloped nation, but is increasingly an international debtor, what evaluation should be places on our huge trade and current account deficits? For the very short run these deficits keep prices and interest rates lower than they otherwise would be and they subsidize our standard of living. But the deficits also are inexorably forcing the dollar down in terms of its foreign exchange value—and no consortium of central bankers, treasury secretaries, et al. can stop the process
A weak currency is not a cause; rather it is a symptom of a weak, noncompetitive economy. In time, of course, a declining dollar will eliminate the deficit in our balance-of-trade. But the price exacted will be a sharp decline in imports, principally oil, and the purchase of foreign services, reflecting our relative poverty and inability to compete in the international economy. The fact that we are the world’s number one producer of smart bombs will not arrest that trend.
The problem is that further depreciation of the dollar will not correct our foreign trade deficit. In fact, further depreciation will only make our stocks and real estate even cheaper and even more attractive as a safe haven in this dangerous would. We are now currently selling our birthright for a mess of pottage. We are becoming a financial hostage to the Pacific Rim, their plantation if you will.
The volume of dollar-denominated liquid assets held by foreigners is extremely large. Any significant repatriation of these funds, by reducing the supply of loan-funds, will force interest rates up – thus increasing the federal deficit and the burden of all new debt. These events alone could trigger a downswing in the economy resulting in more unemployment, more unemployment compensations, less tax revenues and larger federal deficits — truly a vicious cycle.
Unfortunately, in this and other financial areas, expectations become reinforcing self-fulfilling prophecies. No country has become and remained a world power if it is a world debtor and has a weak currency. From these unwanted events we can expect a vicious level of stagflation that will become an enduring feature of our economic landscape. And the United States will be forced into a high degree of economic isolation, operate under a command economy — i.e., into an increasingly totalitarian mold.
We can help terminate these deficits by (1) the U.S. government drastically reducing its overseas military expenditures – or by transferring most of the cost of maintaining bases and personnel to foreign governments; (2) revitalizing a large segment of U.S. industry so that it will be able to compete in foreign markets; (3) sharply reducing our dependence on foreign energy sources; and, (4) increasing the attractiveness of foreign long-term investment in the U.S.
Since actions sufficient to eliminate these deficits are highly improbable, the dollar will eventually decline to a level which will eliminate them. At that level our standard of living, for this and other reasons including financing the federal debt, will be much lower than at present, and the capacity of the Pentagon to project conventional military power abroad will be severely circumscribed.
Since the U.S. is no longer an economically undeveloped nation, but is increasingly an international debtor, what evaluation should be places on our huge trade and current account deficits? For the very short run these deficits keep prices and interest rates lower than they otherwise would be and they subsidize our standard of living. But the deficits also are inexorably forcing the dollar down in terms of its foreign exchange value—and no consortium of central bankers, treasury secretaries, et al. can stop the process
A weak currency is not a cause; rather it is a symptom of a weak, noncompetitive economy. In time, of course, a declining dollar will eliminate the deficit in our balance-of-trade. But the price exacted will be a sharp decline in imports, principally oil, and the purchase of foreign services, reflecting our relative poverty and inability to compete in the international economy. The fact that we are the world’s number one producer of smart bombs will not arrest that trend.
The problem is that further depreciation of the dollar will not correct our foreign trade deficit. In fact, further depreciation will only make our stocks and real estate even cheaper and even more attractive as a safe haven in this dangerous would. We are now currently selling our birthright for a mess of pottage. We are becoming a financial hostage to the Pacific Rim, their plantation if you will.
The volume of dollar-denominated liquid assets held by foreigners is extremely large. Any significant repatriation of these funds, by reducing the supply of loan-funds, will force interest rates up – thus increasing the federal deficit and the burden of all new debt. These events alone could trigger a downswing in the economy resulting in more unemployment, more unemployment compensations, less tax revenues and larger federal deficits — truly a vicious cycle.
Unfortunately, in this and other financial areas, expectations become reinforcing self-fulfilling prophecies. No country has become and remained a world power if it is a world debtor and has a weak currency. From these unwanted events we can expect a vicious level of stagflation that will become an enduring feature of our economic landscape. And the United States will be forced into a high degree of economic isolation, operate under a command economy — i.e., into an increasingly totalitarian mold.