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     Jan 21, 2011

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Hu's dollar frustration
By Hossein Askari and Noureddine Krichene

Our international financial system, based on the US dollar as the dominant reserve currency, faces an unprecedented bout of flu. Following the outbreak of the financial crisis in 2007, the drawbacks of the dollar-based system have become ever more glaring, prompting a number of world leaders and central bankers to voice their concerns, with Chinese President Hu Jintao, at present on a state visit to the United States, and President Nicolas Sarkozy of France becoming its most vocal and influential critics.

The recent decision of the US Federal Reserve to inject US$600 billion into the economy, on top of the prevailing abundance of dollar liquidity, and to maintain near-zero interest rates, has created more tensions around the globe, inciting fears of a


currency war.

In the aftermath of the financial crisis, the Fed has been expanding liquidity at a merciless rate. This planned money creation by the Fed on top of what was done in the aftermath of the financial crisis would lead to a total increase exceeding $2.3 trillion; meanwhile, the US can be expected to lift its debt ceiling above the $15 trillion mark. There is no letting up of liquidity expansion.

As a result of record-low US interest rates and massive dollar injections, there are pressures for dollar outflows to attractive emerging markets in pursuit of higher interest rates. Central banks around the world that want to avoid the depreciation of the dollar (that is the same thing as an appreciation of their own currencies and thus the loss of international competitiveness for their exports) are forced to use their own currency to buy up dollars. This results in a forced expansion of their own money supply, which in turn exerts inflationary pressures in their own markets.

In this way, what started as a monetary expansion and low interest rates in the US is transmitted and exported abroad. Namely, US policies are forced down the throats of other countries. At the same time, commodity prices, including the price of basic foodstuffs, are rising as seldom before because these prices are denominated in dollars while the dollar is depreciating and inflationary pressures are fueled around the world.

It is worth repeating and expanding on an important point from the previous paragraph. Our current international payments system is an asymmetric system because the dollar, the currency of one country, has a special position that no other currency enjoys. Moreover, the US can do whatever it wants with impunity and little or no regard for the problem of other countries.

This was exactly the problem of the Bretton Woods system that prevailed from 1944 to 1971. Its demise can be attributed to two interrelated facts - European countries and Japan were forced into following the policy decisions of the US (or, alternatively stated, there was no policy independence for other countries to pursue their own domestic agenda (this is a direct result of fixed exchange rates); and while the US ran increasing current account deficits, they acquired dollars that could not be exchanged for gold, and the dollars were also loosing real purchasing power in terms of buying internationally traded commodities (as is the case today). Well, it became obvious that the fixed asymmetric Bretton Woods system of exchange rates had to go, as countries did not want to be tied to US policies through fixed exchange rates and accumulate dollars that they did not want.

The world opted for a system that allowed countries to adopt whatever type of exchange rate they wanted - fixed to another currency, such as the dollar, or floating. Well things have not turned out as promoted. Flexible rates did not afford the policy independence that was touted. This is because of the high mobility of capital that responded to even small interest rates differentials between countries. A policy divergence in one country (as a different interest rate) would lead to capital inflows or outflows, in turn nullifying the desired policy divergence. Some of us said that this would happen but it fell on deaf ears.

Today, we see the whole thing playing out again much the same as it did during the problematic period of 1969-1971. Just the names and the countries are different.

Because the dollar is the world’s reserve currency, the US is no Greece or Ireland; it faces no limit to fiscal and monetary expansion. For years, it has been running external (current account) deficits without tears, that is, without facing any balance of payments constraint. Such is not the case for Burundi, for example, which cannot expand deficits without running into foreign exchange constraints.

The dollar depreciation has hurt a number of economies as it essentially exports inflation to these economies; the rates of inflation have exceeded tolerable levels in China, India, and in a number of other countries. US policy makers have little concern for soaring gold, food and energy prices. They are narrowly pre-occupied with domestic political and economic agendas, including coping with a massive unemployment rate of about 9.4%.

The priority of domestic policies was emphasized by President Barack Obama at the Group of 20 summit in Seoul late last year when he flatly dismissed calls by a number of G-20 members to renounce the Fed's injection of an additional $600 billion of liquidity. Similar policies and practices in that earlier era were coined as the policy of "benign neglect". There is little difference today.

Since 2008, the G-20 summits have been calling for near-zero interest rates and enlarged fiscal deficits. But these policies have turned out to be at odds within the G-20 itself. While calling upon China to inflate at a rapid rate, the US and European countries have been critical about insufficient Chinese currency appreciation. In similar fashion, the European zone, while agreeing within the G-20 on the Fed’s expansionary policies and US deficit spending, has been severely critical of the dollar's sharp depreciation and has no choice but to inflate at the same rate to prevent a sharp appreciation of the euro.

Frustrated by the Fed’s deliberate depreciation policy, Sarkozy stated: "We cannot increase the competitiveness of our businesses in Europe and have the dollar lose 50% of its value against the euro. When we produce in the eurozone and sell in the dollar zone, are we supposed to just give up selling?"

Other G-20 countries, such as Brazil and India, have also become critical of the dollar depreciation that has hurt their exports. The Brazilian currency has recently appreciated by about 25% vis-a-vis the dollar, inflicting significant revenue losses for Brazilian exporters.

The Chinese president was critical of the Federal Reserve decision to stimulate growth through huge bond purchases to keep down long-term interest rates, a strategy that China has loudly complained about in the past as fueling inflation in emerging economies, including its own. He said that US monetary policy "has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level." The wrangling and the blame game, as in the past, are alive and well.

The prevailing asymmetric dollar-based system is essentially unstable. It leads to a self-multiplying expansion of US external deficits because dollars acquired by the rest of the world are placed in US banks as reserve assets of foreign central banks. These deposits in turn serve as a basis for further money creation by US banks (as they lend it out), more demand and more external deficits.

Savings from foreign surplus countries enabled US domestic credit to expand at 12% in the years leading to the financial crisis of 2007 and contributed to almost runaway securitization of mortgages, housing boom, and further widening the US current account deficit.

Ironically, in our opinion, the dollar-based system has hurt the industrial structure of the US because the US feels less pressure to expand its exports to finance its imports, it can just print more dollars. Because the dollar is the world's pre-eminent reserve currency, US money expansion and near-zero interest rates have an immediate impact on commodity price inflation, most noticeably energy and food.

Fed expansionary policies also serve as a tax on the world economy in form of seignorage (as printing dollars costs little but foreigners have to give something of value as the accumulate our dollars) for using the dollar as a settlement and a reserve currency. The amount of resources drawn from other countries is approximated by the perennial and growing US external deficits.The money creation amounts to a redistribution of real wealth from poor consumers in Bangladesh and Mauritania to banks, hedge funds, and financial market speculators and traders in New York, Hong Kong, Singapore and in other trading centers.

Continued 1 2  

China leery of Sarkozy's outstretched hand
(May 5, '10)




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