By Dee Woo
The US debt crisis and the recent downgrade of its sovereign rating by rating agency Standard & Poor’s have brought the whole world to a point where there’s great uncertainty about the future. Nobody knows how to respond to a possible US default. The whole world has taken the US’s solvency for granted for way too long. The global trade boom has been so heavily collateralised against the US deficit that we don’t know how it will function in an alternative scenario.
World trade today is a game in which the US produces dollars and the rest of the world produces things that dollars can buy. All the other central banks need to accumulate dollars to keep their currency undervalued against the dollar and retain comparative trade advantage. So what happens if the US government goes bankrupt and the dollars become worthless?
This is really a wake-up call. The world needs to decouple its well-being from the US deficit. We can’t delay the inevitable forever, because next time it will be more than just a close call.
We need to be prepared for a world without the dollar as the dominant reserve currency, and without the US consumption economy as the vital export growth engine. We need the Euro to step up and take over more responsibilities from the dollar. And we need China to unleash a consumption economy to help address the global imbalance.
Otherwise, the world economy will continue to run on inertia — until the dollar and the US consumption economy can no longer support the weight placed on them.
The world has prospered on the debt-fuelled credit binge in the US for decades. Yet, all good things must come to an end.
The dollar hegemony is a curse even to the US
The dollar hegemony has become the US’s biggest disincentive to maintain its fiscal and monetary discipline. According to a report by the Division of Monetary Affairs from the Federal Reserve, since 1990 the US monetary expansion has been driven by the dominant external demand for the dollar. Hundred-dollar notes are the largest denomination now issued by the Federal Reserve, which make up 60 percent of the dollar value of all the US currency outstanding.
The data on the use of $100 notes suggests that the net new demand for them is coming predominantly from abroad. On average over the 1990s, the overseas stock of dollars has been growing about three times faster than the domestic stock. Empirically, the amount of currency outstanding typically grows in sync with, or even a little more slowly than, consumption in the United States.
Indeed, this was the pattern until 1990. However, in the decade after 1990, in tune with the growing external demand for dollars, the US currency grew about 3.5 percentage points faster than consumption in nominal terms. Some may be inclined to suggest these overseas dollars will probably be used to buy US goods and service and therefore boost US employment.
So, where’s the money?
Nothing can be farther from the truth. The majority of the overseas dollars are parked in US Treasuries and other dollar-denominated securities and assets by courtesy of the official foreign exchange holdings and Eurodollar market. They are fuelling a debt-financed domestic demand in the US, which explains the self-enforcing mechanism of the US twin deficits (trade deficit and fiscal deficit).
According to Professor Robert A. Blecker’s research, by the end of 2009, foreign central banks had assets of $4.4 trillion in the US , some 60 percent higher than the overall US net debtor position of $2.7 trillion (see chart). That is to say, excluding this colossal debt to foreign central banks, the US was still a net creditor country to the tune of about $1.7 trillion in all of its other unofficial that is, non-central bank) international financial activities as of end-2009.
Hence, the expanding foreign accumulation of US assets after 2000 was not primarily driven by the increased confidence in the US economy or US assets by private-sector agents abroad, as contemplated in the models of “capital market imperfections.” On the contrary, it was mainly foreign central bank intervention that financed the growing US twin deficits. The dollar’s dominance has done the US a huge disservice as it struggles to maintain its fiscal and monetary discipline: it has facilitated a vicious circle of twin deficits and weak dollar policy by the Federal Reserve. The nature of self-destruction that lies down this path is very clear.
Second, the fact that the US’s money multiplier and velocity are greatly dictated by foreign agents because of the dollar hegemony has rendered the federal reserve increasingly ineffective as a domestic central bank, especially in the time of recovery.
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