The US has consistently run a current account deficit for decades. Doing so, makes it hard for the US Government to reduce deficits. This is not just because of a plummeting household savings rate. It is also because the USD is the world’s reserve currency. In that context, from time to time I have talked about the incompatibility of a national currency being a global reserve currency. This is the Triffin Dilemma. Here’s my read of what this has meant for the global financial system:
it is clear that the US dollar's role as a reserve currency is part of the problem that has led to massive and destabilising global macro imbalances. The problem: national currencies don't work as global reserve currencies. For the US dollar to be an effective reserve currency, the US must run a large current account deficit in order for foreigners to build up US dollar reserves via their corresponding capital account deficit. So, the US dollar's role as a reserve currency requires the US to run trade deficits ad infinitum.
While this could be sustainable over the short run, invariably these deficits build, leading to recrimination and instability or worse when recession hits. For example, after the Asian Crisis in the late 1990s, Asian countries were quite keen on building up a buffer of US dollar reserves to prevent a similar episode in future. The result has been a mercantilist trade policy designed to promote current account surpluses and capital account deficits in Asia in order to build reserves. Much the same dynamic has been occurring all around the emerging markets, in Russia and Brazil in particular. EM countries have built a massive amount of reserves that reflect external imbalances with the US. We now see the protectionist rhetoric that this kind of unevenness creates. And eventually, rhetoric turns into action unless a buoyant economy dampens the calls for protectionism.
So there is a natural tension for the US between its role as global reserve currency creator and its domestic agenda to reduce current account deficits and increase the domestic private sector savings rate. I am speaking of the Triffin dilemma of course. Belgian-American economist Robert Triffin first brought these tensions to light in the 1960s during the Bretton Woods days. But they have not gone away even after the breakup of Bretton Woods in the early 1970s.
Basically, you’re not going to reduce deficits if the domestic private sector wants to spend less than its income and foreigners are accumulating dollars. As long as the dollar is the world’s reserve currency, the only way to get around the government deficit is to depreciate the dollar, which some hoped zero rates and quantitative easing could help do. The trade deficit as a percent of world trade has halved from 6% to 3%. So, you’re going to really need much more than we have seen - a major devaluation, a reduction of reserve currency status or a private sector binge. Of course, zero rates come with a carry trade side effect that increases financial fragility as I outlined in an earlier post.
I don’t see how you fix this unless you accept the government budget deficits, continue to have destabilising and speculative binges in the private sector to reduce savings or ditch the dollar as the reserve currency. Those are the three levers, public sector, private sector, and foreign sector. There are no real alternatives.
That’s my read of what the Triffin Dilemma is telling us.
Here’s Andy Lees of UBS with a slightly different take this morning:
Chart 1 shows world trade (goods and services) has reached new all time highs although not yet recovered to the pre-2008 trend.
(Click charts to expand)
Chart 2 shows that the US current account deficit as a % of world trade has fallen from 6.3% to 2.9%. This means that since the peak there are less dollars being pumped into the system from the current account deficit than the growth in trade, most of which is still settled in dollars.
The Triffin Dilemma says that the US has to run a current account deficit because if it runs a surplus, it sucks dollars out of the system shrinking the money supply of international dollars and thereby causing deflation or contraction in world trade. At the moment it is not that extreme, but insufficient dollars are getting into the system from the US current account deficit to finance the growth in global trade, so the stock of these international dollars is falling relative to the value of world trade. This means the dollars are either getting in through other means to finance global trade, or as appears to be happening over the last couple of months, global trade will have to slow.
Dollars have clearly poured into the system from speculative capital -(almost certainly on the back of QE) - which means that there is a risk behind it. People are short dollars and at some stage they will have to be bought back. A lot of those dollars have come from European banks borrowing dollars, or from US banks increased exposure to Europe - (recent BIS data showed US banks exposure to peripheral Europe is USD640bn for example). The short can go on for a long time, but with QE2 now ended, with talk of a tax immunity for bringing profits back home, and with the Brent/Texas oil spread getting back towards its all time highs - (Citigroup expect Brent to rise to a premium of USD40 or more to West Texas compared with the present premium of USD17bbl, presumably putting European industry at a severe disadvantage) - and hopefully the US about to address its budget deficit, the cost of holding that short dollar position, let alone growing it which would be necessary for the divergence to continue, seems set to rise.
Chart 3 shows the divergence between world trade and global FX reserves has gone exponential since 2002 and almost vertical over the last year to USD5.6447trn. Reserves accumulated within the private sector from companies that are happy to sit on them would add to this divergence but lets just concentrate on this USD5.6trn. Some of that capital flow will be FDI and a lot will be short term speculative money. That figure is up by over USD1trn in the last year alone and up USD2.1trn since June 2008 and up by USD5.6trn since June 2003 which is USD700bn a year. The figures are astounding.
The longer the divergence continues between the growth in world trade and the growth in the US current account deficit, unless that trade is being done in another currency, the higher the percentage of speculative dollars must be in the stock of international dollars meaning a greater risk of a violent unwind and a big dollar squeeze. With QE2 now ended, I am not willing to run the risk of this turning; the risks of being short the dollar are just too high.
Sounds like Andy is dollar bullish. I would also add that we saw a huge surge in the USD during the panic in 2008 and 2009, presumably because the same forces were at play. When I hear talk of European sovereign debt crisis contagion, I think a lot about US money market funds de-funding European banks and creating the pre-conditions for those central bank swap lines being used all over again. Why regulators are allowing these institutions to become exposed to short-term dollar funding is beyond me. So in the end I agree with Andy that being dollar short exposes one to a potentially violent reversal when the dollar is the reserve currency in a world of uncertainty. That could prove painful.