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Sunday, May 25, 2003

On the So-Called Dollar Problem

Richard Duncan has a book out on the so-called 'dollar problem' that reflects one view of the worlds problems. These arguments seem to me sufficiently widespread to be worth examining more fully:

During the 30 years since the breakdown of the Bretton Woods International Monetary System, the global economy has been flooded with dollar liquidity. International reserves are one of the best measures of that liquidity. During the quasi-gold standard Bretton Woods era, international reserves expanded only slowly. For example, total international reserves increased by only 55% during the 20 years between 1949 and 1969, the year Bretton Woods began to come under strain. Since 1969, total international reserves have surged by more than 2000%. This explosion of reserve assets has been one of the most significant economic events of the last 50 years.

Today, Asian central banks hold approximately $1.5 trillion in US dollar-denominated reserve assets. Most of the world's international reserves come into existence as a result of the United States current account deficit. That deficit is now $1 million a minute. Last year, it amounted to $503 billion or roughly 2% of global GDP. The combined international reserves of the countries with a current account surplus increase by more or less the same amount as the US current account deficit each year. So central bankers must worry not only about their existing stockpile of dollar reserves, but also about the flow of new US dollar reserves they will continue to accumulate each year so long as their countries continue to achieve a surplus on their overall balance of payments. With the depreciation of the dollar rapidly gaining momentum, Asian central bankers are scrambling to find alternative, non-dollar denominated investment vehicles in which to hold their countries' reserves. Consequently, this is a topic that is attracting considerable attention in the press. There is a related issue of much greater importance being entirely overlooked, however. The surge in international reserves has created unprecedented macroeconomic imbalances that are destabilizing the global economy. The global economic disequilibrium caused by these imbalances is the subject of this article. It is also the subject my recently published book, THE DOLLAR CRISIS: Causes, Consequences, Cures (John Wiley & Sons, 2003).

Since I do not consider myself in any way an expert in currency matters. You have already had my brother's opinion, now I've just had feedback from Kevin, my man at the battle front.

I must first admit a prejudice against books in which everything that
is wrong comes down to one issue. The fact is that (with the obvious exception of demographics) it never all comes down to one issue.
Before getting down to core issues I note that high up in the article Duncan claims "Asian central bankers are scrambling to find alternative, non-dollar denominated investment vehicles in which to hold their countries' reserves" due to the recent slide in the dollar's value. This is, as far as I can tell, a bit of an exaggeration. Asian Central Banks have done considerable adjusting of reserves since the exchange rate swings of the mid-to-late 1990s. Swings in exchange rates were bigger then and the reliance on the dollar in reserve holdings higher. Central banks may be uncomfortable with what is going on now, but they have reduced their dollar exposure somewhat and are not "scrambling" again, as far as I know. The problem with the "scrambling" claim is that it makes me doubt Duncan's thinking on his central theme, as well.

I have the impression Duncan wants to write about a dollar problem, about one issue, but what he really sees is a fiat money problem, a problem with global investment flows, overshoot, a pegging problem and a number of other problems inherent in the modern monetary and financial system. Lumping them together as a dollar problem give the impression that there is a simple answer to global financial woes, when there is not. For instance, Duncan claims the "Dollar Standard" has allowed massive
credit creation that has led to over-investment in industries around the world. I'm not clear on why that is a "Dollar Standard" problem, instead of a fiat money problem. The stacking up of reserves "those dollars enter their domestic banking system and, being exogenous to the system, act just like high powered money" needn't lead to the creation of high-powered money. That is a problem for the local central bank. Fairly unfettered financial markets do allow transmission of monetary policy across boarders. If having a single predominant reserve currency for a few decades has fostered globalization of financial markets, then the problem of monetary policy leakage has been worsened by the "Dollar Standard", but it was not created by that standard.

Another worry is that he claims the same overheating and asset price hyper-inflation for both the US, as the deficit country, and those countries piling up dollars, as surplus countries. I'm not quite sure why the debtor and the creditors should suffer the same hyper-inflationary fate in asset markets beyond the fact that monetary policy is transmitted across borders. Again, local central banks have some control and, to the extent they do not, it is a problem of globalization of financial markets, not of US imbalances and dollar reserve accumulation, per se.

There is also a sort of chicken-and-egg problem here. If imbalances are leading to asset hyper-inflation, the implication seems to be that foreign central banks have no choice but to hold US assets. This must, I think, mean that trade is primary and that financial flows are derived from trade flows. Central banks do have a choice. If they had not held US assets in reserve, there would have been a profound difference in trade outcomes, perhaps a far smaller imbalance in trade over time. The choice to accumulate massive reserves has to raise the suspicion that there is a policy to run a trade surplus as a source of growth. This, too, is a separate issue from the "Dollar Standard".

There is a reasonable peppering of more standard thinking. The Thai lending crisis was due in part to unlimited access to dollar loans. Excess capacity does threaten deflation. There is nothing new, however, about offering a lot of data tables, side arguments and such, then asserting that these lists and arguments support one's main thesis, when they do not. Here is Duncan's attempt: "Hopefully the preceding paragraphs have clarified how unprecedented US current account deficits have sparked off extraordinary credit creation in those countries with the corresponding surpluses, causing unsustainable economic bubbles which subsequently implode, leaving behind wrecked banking systems, heavily indebted governments, excess capacity and deflation." I'm just not convince that they do clarify. Thais had reckless access to dollar loans because of a pegged currency the baht didn't vary in value against the dollar, so why not borrow in the lower interest rate currency? That is not a current account driven problem.

I am very willing to hear a contrary view.I'm writing this on the fly and it is probably a bit shy on textbook sorts of thinking. However, I think there is a shortage of adherence to the textbook in Duncan's bit, too. Are the problems he seeks to solve really mysteries that require a "Dollar Standard" view to understand?

Just can't help myself. I was sure I was done. I mentioned the Thai crisis, which grew largely out of the baht being tied to the dollar. Think of the Mexican peso crisis. It was an election cycle event, with Mexico issuing Tesobonos dollar denominated debt on the way to the election to "stabilize" the financial situation ahead of the election. It also meant that the Bank of Mexico had to redeem the Tesobonos with dollars when they matured, which coincided with the early days of the Chiapas uprising, which sent foreign investors fleeing and made raising reserves in adequate amounts impossible. Certainly, a dollar-linked event. However, it was a parochial domestic policy
decision, in a pegged fx regime, that made the difference. Rather than having too high a level of dollar reserves, the Bank of Mexico had too few. If Duncan wants to argue that this fits his model, then it really comes down to a problem of reserve management, rather than the dollar.

That, I suppose, gets me back to my original objection. Given the same trade policies, the same savings rates, the same mismatching of assets and liabilities that Duncan relies on in his analysis, it wouldn't matter if there were one major reserve currency or three. The outcomes would have been pretty much the same. So instead of a single, simple problem, we have the same multifarious set of problems that we already knew about.

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