It's Good to Be the World's Reserve Currency

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I decided to write this piece because of a short post at Alea; rather than comment there, I thought I would post something slightly longer here. Consider the similarities between the US and Britain in the current crisis:

• Accommodative monetary policies.
• Generally free-ish with respect to financial regulation and credit.
• Overleveraged housing markets after a bubble.
• Banks that felt they could hedge risks and enhance returns through structured finance and derivatives.
• Aggressive approaches to bail out financial institutions.

There’s probably more, but now I want to highlight one difference: the US Dollar is the global reserve currency and the British Pound is not. Thus Britain, as it tries to reflate, runs up against borrowing constraints faster than the US does. Those limits aren’t showing up in their interest rates yet, but it is showing up in the currency, which has been falling rapidly of late.

With the creation of so much liquidity out of thin air, the surprise is not that the British Pound is weak, but that the US Dollar is strong, and still regarded as a safe haven. Then again, what are the alternatives?

The Yen? Japan has its own problems, and their economy is not large enough to deal with all of the financial flows entailed.

The Yuan? Banking system too immature.

The Euro? Too young. The current danger of the Euro is not that it will be weak, but that it might be too strong, leading to hard adjustments in Ireland, Spain, Greece, Portugal, and tangential European economies with weak fiscal policy positions. I’ve said it before; I’ll say it again: The Euro is a noble experiment, but currency unions that are not political unions don’t typically work. Then again, most fiat currencies eventually fail.

External commodity-based currencies? None that I know of; few governments want to limit their power by tying their hands on monetary policy.

That leaves the imperfect US Dollar. For now, lending to the US remains open, despite the many problems, and the paltry compensation for lending to the US Government and those that they guarantee to varying degrees.

If you live in the US, it’s a small reason for optimism that we don’t deserve, but it allows our government to borrow more. Now, whether they will use it wisely is dubious, but things could be worse. Ask Britain.

Comments

[DiggerUK:]

Agree with your comments on the european situation "currency unions that are not political unions don't typically work"

If powers that be over here aren't going to push this issue, their political clout in the world will suffer, along with our economies.

It might happen swift and smooth, there again it might end up like the scene in "Life of Brian" were the two factions going to kidnap Caesar's wife meet.

Jan 21 04:17 PM

[Pilm:]

another consideration, when all these foreign countries run out of money reserves (which they are in the process of doing), it won't matter what the reserve currency is, will it?

the oil nations won't run surpluses with low oil. china is planning to send big bucks at home, will also experiencing lower exports. european surpluses are toast. japan is on life support. don't really see where a sustainable source of reserve money is going to come from.

Jan 21 05:10 PM

[Chuch:]

I agree, but with massive spending from obama, that may not be the case for long, see here crashmarketstocks.com

Jan 21 05:57 PM

[Thomas J. G...:]

I'm pretty sure yesterday (1/20) for the first time in a long time US treasury bonds went down in principal price when the stock market was really down and bank fears were high. Maybe people are realizing that the U.S. is attempting to borrow/print money their way out of their problems.
Great point about other countries having a real constraint on their gov't deficit spending that the U.S. does not. I have the feeling if the U.S. fed gov't hadn't run such big deficits over the last 40 years we wouldn't be having these problems.

Jan 21 06:25 PM

[Vox Rationalis:]

"The Euro is a noble experiment, but currency unions that are not political unions don’t typically work."

I'm curious: how many other examples of this are there?

Jan 21 06:33 PM

[nova:]

Yes indeed, other foreign currencies are not too good to replace US$ as a reserve currency.

A reserve currency concept is appealing. However, based on a way the USA are printing money, it becomes more and more appealing to have a no-reserve currency system instead of a worthless one.

Here comes another terrible mistake US political & financial leadership is making: assuming that, no matter what, US$ will continue to be a reserve currency. Sorry, not for long.

Jan 21 06:55 PM

[Moon Kil Woong:]

Yes it's good. Unfortunately 1) the US has been abusing by being fiscally insane since Bush Jr. and 2) in order to be the reserve currency you must have massive amounts of debt owned by foreigners swashing around and 3) your economy must be dependent on imports. Good or bad? Good because you get to consume beyond your means for decades, you get to dominate markets like the oil market (even though it's an oligopoly the US has a monopoly on huge single country consumption), and you get lower inflation. Bad because a variety of reasons which highlights the fact although everyone wants to be the global reserve currency no one else wants the position of world leader of overconsumption, reigning title holder for the most massive structural debt in dollar terms (others win biggest debt to GDP thank goodness), biggest annual trade imbalance outflows, and a waning economy.

At least we have a stable government and civil liberties that still spur innovation. So all is not lost. Let's get our ship back in order after the punishment we took during the Bush Jr. storm of stupidity.

Everyone plays their roles. Hopefully, we won't be the inevitable dupe.

Jan 21 07:00 PM

[Alan Tomlinson:]

With respect to your comment: "The Euro is a noble experiment, but currency unions that are not political unions don’t typically work. Then again, most fiat currencies eventually fail." In what way do you think that the EU is not a political union with respect to your comment? You seem to be of the opinion that the US dollar is the reserve currency because it was always so.

Jan 21 07:24 PM

[GloomBoom.com:]

The dollar is strong for the moment but will not hold. By 2010 the dollar will tank. Gold is the place to be.

Jan 21 08:11 PM

[otbricki:]

The EU is not a political union. That is pretty obvious. You will know it is one when France, Germany etc. disband their national armies to form a European army under control of a central European government with the power to levy taxes on its member states and the individual European states recall their ambassadors. Also there will be one seat at the UN for Europe.

Most fiat currencies eventually failing is silly in its obviousness. All currencies eventually fail, fiat or not unless they are based on the actual value of the specie in circulation.

Finally the US is the world reserve currency. It is not based on the fact that it used to be so. It is based on the fact that it is that way now. The world's central banks hold 4 times more dollar than Euro reserves.

The only current possible alternatives have fatal flaws. The Euro is not backed by a sovereign guarantee so it is completely unsuitable. Japan is too small. China is even smaller and does not have a floating exchange rate.

On Jan 21 07:24 PM Alan Tomlinson wrote:

> With respect to your comment: "The Euro is a noble experiment, but
> currency unions that are not political unions don’t typically work.
> Then again, most fiat currencies eventually fail." Do you have any
> evidence at all for these comments or are you just writing? Moreover,
> in what way do you think that the EU is not a political union with
> respect to your comment? You seem to be of the opinion that the US
> dollar is the reserve currency because it was always so. You come
> across as an empty suit to me, but perhaps your ideas in this article
> were much better thought out and nuanced before your editor obliterated
> them.
>
> Cheers,
>
> Alan Tomlinson
>
> P.S. For what it's worth, I use my real name because I think that
> if you lack the conviction to sign your name, your opinion is worthless.

Jan 21 10:23 PM

[japan20000:]

It is surprising to see little discussion about what ultimately backs a currency. That would be the economic output and the ability to secure it in the future. And I do not remember seeing on this post more broad considerations such as the fact the Americans have all possible natural resources under their feet, which cannot be said about Europe, and they have ONE 300-million-people market in which they can be put to use (as opposed to Europe that is reminiscent of feudal times in this respect). They also have an army to protect that economy and its external markets and suppliers. Does UK have any of this? Does Europe have any of this?

Jan 21 10:48 PM

[Lonestar1:]

There will be increasing pressure to put $ under international supervision if US wants to continue to enjoy the reserve currency status. It is unlikely US would budge to such pressure unless all countries on the Eurasia continent speaks with one voice. The US strategy, of course, is to prevent such possibility. US presence in central Asia; insistence on deploying missile defense shield in Eastern Europe, are all for this purpose. The result of this crisis can not be pretty. It may result in a collapse of global trading system and rise of protectionism. The sharp decline of trading volume + an uneasy gyration about the $ are pointing to that direction

Jan 21 11:42 PM

[Tradememe:]

It is true that there is no other currency to replace the USD. But other countries need only to reduce the proportion of USD in their foreign exchange reserves for the US to feel the effect.

Jan 21 11:44 PM

[Simon Smelt:]

Two points;
(1) "currency unions that are not political unions don’t typically work":
In fact, pre Euro, the currency union of Belgium and Luxembourg worked just fine.
(2) On the Euro:
It's a matter of which of the US $ and the Euro is the least bad. Don't count on the lack of political union and associated lack of "sovereign guarantee" for the Euro to continue to give the U.S. $ the advantage. It probably rests with the U.S.'s big creditors (China, Saudi et al) to decide when they've had enough. Indications are they are trying to re-balance out of the U.S. $ already.

Jan 22 02:00 AM

[Smarty_Pants:]

"With the creation of so much liquidity out of thin air, the surprise is not that the British Pound is weak, but that the US Dollar is strong, and still regarded as a safe haven. Then again, what are the alternatives?"

Yes, that's the problem. Everyone is printing money like crazy in an attempt to reflate the bubbles in non-productive malinvestments. For now, the lack of superior alternatives seems to be enough to keep the dollar at the top run of a crumbling ladder.

Eventually it will be impossible to dispute that the ladder is crumbling and there will be a mad scramble to do something about the situation. Whether that means a return to a precious metal backed currency, or some other new form of fiat as a world reserve no one can know, but change will happen.

What remains to be seen is the timing and implementation of the switch to something new.

Whatever the result, I would guess that gold prices would continue to be quoted in the new reserve currency and that anyone holding gold would be able to convert their savings into it with little difficulty. After all, the central banks of the world would need to do something with all those metric tons of gold sitting in vaults.

Jan 22 10:03 AM

[iyamwutiam:]

The persistent expansion in the money supply has been accompanied by a decline in the efficiency of money to generate GDP. In 1981, two dollars in the money supply (M3 - $2 trillion) yielded three dollars of GDP ($3 trillion), a ratio of two to three. In 2005, $10 in the money supply (M3 - $10 trillion) yields $12 of GDP ($12 trillion), a ratio of two-and-a-half to three. It now takes 25% more money to produce the same GDP than 25 years ago. That 25% is the unproductiveness of debt that has infested the economy, not even counting the unknown quantity of virtual money that structured finance creates.

from www.atimes.com/atimes/...

Henry CK Liu for Federal Reserve Governor is all I say

Jan 22 06:20 PM

[Vox Rationalis:]

"The persistent expansion in the money supply has been accompanied by a decline in the efficiency of money to generate GDP."

First off, use quotes if the words aren't yours.

Secondly, this is quite the cherry-picking. Why not use M1 or M2, as opposed to somebody's guess at M3? If you run the same data for M1 or M2, the change is not nearly as dramatic (GDP/M1: 1981 - 7.1; 2005 - 8.7. GDP/M2: 1981 - 1.78; 2005 - 1.83). Both GDP growth and price inflation have tracked much more closely to M1 or M2 growth than to M3 growth. Seems to me that M3's value is overstated by many.

Lastly, this is meaningless. The money supply doesn't generate GDP, and besides, as long as real GDP growth is good and inflation's in check, who cares about money supply growth? What is the goal here - to make money function more efficiently (whatever that means) or to grow real GDP?

Jan 23 09:03 AM

[iyamwutiam:]

Dear BS- corrected upon the quotes - sorry.

Did you read the article? Henry CK Liu is an excellent economist and one of the true thinkers of our time. I encourage you to read his works at henryckliu.com

Jan 30 10:21 PM