The Dollar: Rumors of its death are greatly exaggerated

There has been much discussion this year over the possible development of a new global reserve currency which would displace the dollar.

In an essay in March 2009, People's Bank of China governor Zhou Xiachuan had outlined a plan to expand the use of Special Drawing Rights (SDRs), a basked of currencies used by the IMF and its member countries as an accounting construct, to basically begin the process of phasing out the prevalence of the US$ as a global reserve currency. This essay has generated significant attention and in fact, has done damage to the greenback.

However, fears of a dollar-replacing SDR currency may be misplaced.

1. About 65% of China's ahrd currency reserves, earned since China opened its doors to world trade in 1987, are in US assets. Any precipitous drop in the US$ would be calamitous for China's "savings". And one thing is certain, which I can say having taught in and studied China since 1993, China's macro policy, so far, has been brilliant. They will not push for anything that will be deleterious, or destabilizing, to their economy.


China's reserve growth 2000-2009 (Source: Brad Setser)

2. So why this talk of SDR's coming from China?

Simple. China sees the US running nonsustainable deficits and if growth gains traction in the US, they see rapid inflation which will erode away the dollar (and hence the real value of their savings). The SDR rhetoric is simply a short across the US macro bow that says "Hey, you macro-guys in the US, you'd better watch that deficit, and the impending inflation that will come with it. And keep in mind that this humongous amount of money that you are printing cannot be easily withdrawn!"

3. It is true that we have been monetizing like crazy, but why can't we simply vacuum the excess money back in to prevent inflation, when the economy picks up?

This is because of the rampant monetization that has been done by buying toxic sub-prime assets from malfeasant lenders. To "undo" the monetization, these assets, persumably now non-toxic, would have to be sold back to investors. The probability of them becoming "non-toxic" is not significantly large (less than their becoming more toxic as time progresses) - hence the worries of inflation if the economy gains traction.

4. So coming back the SDR challenge to the reserve-currency status of the US dollar - what is the final word?

We hold currency for two major reasons: As a store of value, and as a medium of exchange. It is the first one - the store of value - that is vitally important. And "value" is endogenous. A currency is awarded value by the world community. A currency becomes a reserve currency because the rest of the world is comfortable holding on to it, and accepting it in lieu of exporting goods and services. Reserve currencies are earned and not announced. It is like respect - you earn it, you do not command it or negotiate for it. So yes, the SDRs may be a decent unit for accounting (another basic function of "money") purposes, but will only be as strong as their weakest member countries' economies.

Keep in mind, that the largest component of the SDR today is still the US$ (at 44%), followed by the Euro (34%), the Japanese Yen (11%), and then the British Pound (11%). So the SDR, were it to gain acceptance, would still have to have the US$ as its main ingredient. But if the Eurozone or the UK or Japan were to tank, then this would undermine reliance on the SDR.

In summary - don't sell your US$. Yes, the dollar is under siege, and has been mauled, but, given the state of the global economy and the extraordinary resilience of the US, the dollar will continue to be awarded the status of the planet's reserve currency by the world community.


Dr. Farrokh Langdana, Ph.D.
Rutgers University Business School


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Monetization Demystified

There is a lot of talk (finally) about how the Fed is simply "printing money" to pay for the unprecedented increases in spending and deficits. Economists are going on about how Bernanke's monetizing the deficit. Is this is the same as "printing money"? And, how is this different from borroing by Uncle Sam via the Treasury?



Here is a Monetization primer that will hopefully clarify exceptionally important issues - especially given the US is well into non-sustainable deficits.

The Treasury

When the Treasury borrows from domestic and foreign (Chinese) lenders, it issues new government debt: Treasury bonds and Notes. This borrowing used to be done at four large auctions every year - now they are almost a weekly feature. This borrowing finances "G" - government spending.

If the Treasury finds no lenders - or insufficient lenders - it has to simply "sell" these new government bonds to the Federal reserve which "pays" for these by simply creating money out of this air. This is known as "monetization" of government deficits and is extremely dangerous. On a large scale - as it inevitably is - this leads to hyperinflation. Note: Since President Nixon closed the "gold window" in 1971, there is no more gold anchor. Since 1971, there has been nothing restricting the creation of money by the Federal Reserve.

The Fed

To increase money for normal operations (i.e. not for monetizing the deficit), the Fed simply buys previously issued (not new) Treasury bonds from local banks and creates money to increase the growth of the monetary base and to lower short-term interest rates known as the Federal Funds Rates. To shrink money in circulation and to raise the short-term rates, the Fed sells government bonds to local banks - it reverses the process. These are Open Market Operations, not to be confused with Monetization.

Since Fall 2007, the Bernanke Fed has bought Trillions in toxic debt (rotten mortgages) from financial institutions, etc. Including, by way of example, this empty shopping mall in Oklahoma City (yes, believe it):


Empty Shopping Mall in Oklahoma City owned by the Federal Reserve

This process has been labeled the great "Stealth Monetization" by the Fall 2007 Rutgers EMBA class.

This monetization went largely unnoticed, and most important, this is a "toothpaste" monetization. Like toothpaste, this money is easy to print and impossible to put back. When the time comes to shrink the monstrous amount of money created by the Fed - unprecedented in human history - we will be unable to"vacuum back" this money creation. Who will buy back the toxic debt? Certainly not the same financial institutions that were delirious when the Fed took it off their hands at above-market value. This is the new and more insidious monetization that has cropped up since 2007.

Hopefully this clears up the confusion between Government spending, Open Market Operations, and Monetization - both conventional and stealth.


Farrokh Langdana, Ph.D.
Rutgers University Business School

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Playing Chicken with Trade

"China is expected to ban imports of US Chickens in coming months", reports the WSJ.

This move is, in part, retaliation for the 2008 U.S. ban on imports of processed chicken from China, but is also part of a broad global trend toward protectionism - which is being led by the US.

Repaying organized labor for their massive political support in the most recent election cycle, Congress inserted the notorious "Buy American" provision into the stimulus bill in February. Three weeks later, Congress banned Mexican Trucks from entering the U.S., in a clear violation of the NAFTA treaty.



These protectionist moves have led directly to harmful consequences for the USA, for example:

* China has begun to enforce "buy Chinese" requirements for investment related to its own RMB 4 Trillion stimulus package.

* Mexico, in addition to suing the US over the trucking ban (which will have no effect as the US consistently ignores unfavorable WTO rulings), has retaliated by "imposing tariffs of 10 to 45 percent on dozens of U.S. exports ranging from fruit and wine to washing machines".

* Canada's national and local governments are considering retaliation for the "Buy American" provisions.

This takes place as world trade continues to collapse as a result of the economic crisis:


http://www.cpb.nl/eng/research/sector2/data/trademonitor.pdf

Meanwhile,

* The Doha round of world trade talks languishes because of the intransigence of developed nations on their farm subsidies.

* The US continues to support ethanol mandates and subsidies, regardless of the effect on food prices (which cascades down to affect the poorest nations of the developing world).

* Fully negotiated US bilateral trade agreements with South Korea and Colombia gather dust and remain unratified due to the political influence of organized labor.

* The climate bill passed by the US House of Representatives last week includes provisions to impose tariffs on goods imported from countries that don't match U.S. carbon-dioxide restrictions". China and India (against whom these provisions are clearly designed) are already objecting strongly.

Simple self-interest dictates that the US forcefully advocate for free and open trade. The US is by far the biggest trader of goods and services in the world, accounting for 11% of world trade and exceeding both Germany and China, its nearest rivals, by 30%.

The dynamics of local and regional politics dictate that legislators will almost always put provincial politics ahead of the national interest when it comes to trade. For this reason, only strong leadership by the US Executive can stop the global slide into Trade Protectionism.

To-date, this leadership has been absent. The best that President Obama has mustered so far does not exactly qualify as a ringing defense of open trade: “I think we have to be very careful about sending any protectionist signals out there.” (NYT, June 29 2009).

The US is far beyond sending mere "protectionist signals". It has in fact put itself on a collision course with its largest trading partners over trade issues of its own making.

In a global trade game of chicken, nobody wins.

-Peter T. Murphy, 2-July 2009

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Credit creation versus Debt relief

Increased savings is a symptom of the ongoing debt-deflationary condition of the economy, argues the author in this article, courtesey of Lincoln Rowley, REMBA'09: Debt Deflation in America – What the Jump in the U.S. Savings Rate Really Means by Michael Hudson.

Michael Hudson makes an important point:

"The trillions of dollars that the Bush and Obama administration have given away to Wall Street would have been enough to buy a great bulk of the mortgages now in default – mortgages beyond the ability of many debtors to pay in the first place."

The Government has committed Trillions of dollars (over $12 Trillion and counting) to bail out institutional Creditors (Banks) rather than Debtors (Citizens), in the misguided belief that we need more lending. "Hair of the dog" may be an effective pallative for a hangover, but a crisis caused by overindebtedness is unlikely to be cured by creating additional debt.


Hair of the Dog
Photo Source: http://www.housepetmagazine.com/dog_events_newyork.htm

There are two sides to a loan - the lender, and the borrower. Unfortunately for the Government's strategy, no matter how much "liquidity" is provided to lenders to support the supply of credit, the appetite among borrowers to take on more debt (the demand for credit) has disappeared. This shift in attitude is evidenced by the soaring savings rate, and, is unlikely to be temporary.


Data Source: http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=75&Freq=Month&FirstYear=2009&LastYear=2009

"It is wrong to squander the taxes of ordinary citizens and put a burden of indebtedness on our children in order to protect the bondholders of careless and poorly-managed financial institutions" - John Hussman, Ph.D.

John Hussman has written cogently on what would have been a more proper use of taxpayer resources to address the heart of the problem - falling real estate prices which continue to drive a chain reaction of defaults throughout the financial system.

The concept is that the Treasury would administer a program whereby lenders write down the underwater portion of a distressed mortgage, and transform the written-down portion into an equity position in the property (a "Property Appreciation Right", or "PAR"). These "PAR"s would be pooled and administered by the Treasury. This solution deals directly with debt relief, rather than credit creation.

Read the article at http://www.hussmanfunds.com/wmc/wmc090223.htm

A point made in both articles is that government aid to financial institutions, rather than directly to distressed debt relief, has been misguided. Dr. Hussman makes the point that equity and bondholder capital in the banking system was, and remains, more than sufficient to cover bank losses on distressed debt. The various bailouts to-date have simply transferred wealth from present and future taxpayers to bank bondholders.


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Cave Theory

"When the entire world is running into their caves, the country with the best cave wins."
- Langdana Cave Theory (paraphrased)

In the global flight to safety last fall, the dollar, which had been in decline for years, rallied strongly as the world rushed to what was perceived as the safest asset, relative to others, on the planet.

Mike Shedlock's article today in Minyanville discusses the current pessimism about the US dollar, due to all the debt being issued - and the fact that the pessimists are ignoring the fact that the entire world is engaged in the same deficit-spending activity.

Here's the link to the article:
http://www.minyanville.com/articles/CHINA-dollar-euro-FXI-UDN-CMC/index/a/22892

Dollar bears: beware !




- Peter T. Murphy, 2-Jun-2009

"GAME OVER"? Perhaps not...

“During a recession of this severity it is important, as I explained, for the government to step in and fill the hole in demand that was created by consumers and by businesses, to get the economy kick-started.

But the long-term deficit and debt that we have accumulated is unsustainable. We can't keep on just borrowing from China, or borrowing from other countries -- (applause) -- because part of it is, we have to pay for -- we have to pay interest on that debt. And that means that we're mortgaging our children's future with more and more debt, but what's also true is that at some point they're just going to get tired of buying our debt."

- President Obama, speaking at New Mexico town hall meeting, 14-May 2009


SUSTAINABILITY

The Dornbusch model of the sustainability of bond-financed budget deficits is the benchmark for gauging deficit sustainability.

Generally, if the ratio of Fiscal Budget Deficit - to - GDP is less than 5%, the bond-financed budget deficits in mature economies such as the US, Japan, and Western Europe, are said to be "sustainable". That is, they can be perpetually financed by "rolling over" the debt.



In the Dornbusch model, this 5% coincides with the real (inflation-adjusted) interest "lost" on government debt being less than the growth rate of the economy. In other words, as the size of the economic pie grows faster than the interest paid on government bonds, all will be well.


NON-SUSTAINABILITY

Over 5%, well, that's another story. Here the budget deficit becomes "nonsustainable". Domestic and foreign lenders refuse to lend Uncle Sam any more $ -- they refuse to buy any more of our Treasury bonds-- and a mind-numbing inflationary monetization becomes inevitable. Unable to finance its budget shortfall by borrowing, the Government will simply print money. For the non-economists: We then have to print money like crazy and we basically go into hyperinflation.

At that point, our collective ATM dispenses only two words: “GAME OVER”!




THE SITUATION TODAY

So how are we right now in May, 2009? The 2008 deficit/GDP ratio was 3.2%, well under the 5% limit established by the Dornbusch model, but by December 2009, thanks to the massive spending of the Obama plan, we will be at 13% (this estimate directly from the Congressional Budget Office) !

The US has not seen levels like this in 60 years. (war-time deficits, as seen in the graph, are generally temporary, and can be manageable - if your side wins!).


Source: usgovernmentspending.com


REASON FOR HOPE

We're clearly well-past the 5% Dornbusch limit. But wait! Is this the end? How dangerous is this? There is hope---there may be some mitigating circumstances.

This time, with the whole planet in recession, there is no other safe haven. Even at 13% deficit/GDP ratio, the US economy is still the world's most resilient. Where will the Chinese send their savings? Europe? Not likely. Furthermore, US reliance on foreign lenders may be abating, as domestic savings continues to rise.



So as long as global contagion causes the recession to be a worldwide phenomenon, we may dodge the deficit bullet after all, and still manage to confound Dornbusch and be sustainable at 13%.

If I am wrong, buy gold--the real thing, the shiny metal. And a safe.


Dr. Farrokh Langdana, Ph.D.
Rutgers University Business School



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