Monday, December 13, 2010

what if the us$ was not the world's reserve currency?

A friend asked me,

What is your take on if the U.S. dollar loses its reserve status as the world's reserve currency? In today's economic environment and the government's incessant use of QE, what are the chances of the U.S. losing this status, and if we do, what does that look like for the American people the next day when they wake up after it happens?

There are a few questions there. I may oversimplify too much, or too little, for some but let's take them one at a time.

Q. What will happen if the dollar is no longer the world's reserve currency?

A. Not much. Maybe interest rates on U.S. government bonds would be a little higher.

Why? Countries like China or oil-rich Arab states do not hold excess cash but buy Treasury bonds with their excess cash. (U.S. bonds do not pay much in interest but it is more than the zero return on holding cash.) If the foreign demand for U.S. Treasury bonds goes down then the federal government would have to pay a bit more in interest to sell its bonds.

The British pound was once the major reserve currency in the world and started losing ground to the U.S. dollar after WWII. Britain is doing just fine. Being a reserve currency is not a big deal. It just means there is a larger demand for government bonds which are denominated in the currency.

Q. If the dollar stops being the reserve currency, what would it look like the day after it happens?

A. It won't happen in a day. It would happen over years. It will not happen soon.

Individual countries decide how they hold their reserves. We see some diversifying their reserves now rather than holding everything in dollars. Putting all the eggs in one basket is not a good idea.

What would be the substitute for the U.S. dollar? The euro? The Chinese yuan? Well, the euro is the most likely alternative. However, given the financial crises in various European countries, no country would choose to load up on euros for their reserves right now. The yuan is not a convertible currency so it can not be used as a reserve currency yet.

Q. Will QE (quantitative easing) hasten the loss of reserve status.

A. In all likelihood, no.

There are several ideas and issues implicitly embedded in this question:
  • First, if U.S. inflation is much worse than another countries, then the dollar is losing value faster than other currencies. This would tend to cause a flight out of dollars as countries would rather hold reserves in other currencies. (Even this might not happen if the interest rates on U.S. bonds were high enough to offset the expected higher inflation in the U.S.)
  • Second, QE (quantitative easing) is the Federal Reserve System (a.k.a. the Fed) buying up government bonds in the open market. They create money by doing this, and more importantly, create the potential for even larger increases in the money supply as banks could create additional new money. (A very long, complicated story as to how and why. I'll spare you.)
  • Third, a large increase in the money supply can set off inflation, thus QE may cause the U.S. dollar to look relatively unattractive as a reserve currency.
However, the above chain of reasoning is not happening and is unlikely to happen. The money supply is not growing, as it would with QE in normal times, and therefore is not causing rising inflation rates.

The money supply is not growing because so many banks are in trouble or afraid of getting into trouble. Banks are holding huge amounts of excess reserves -- funds in excess of what they have to hold to back up deposits -- funds they could loan out and create new money. Banks are not making loans, money is not being created. To give you some idea of the magnitude, a couple of years ago, in more normal times, commercial banks had $8 billion in excess reserves. Now they have well over $800 billion in excess reserves.

That is a lot of potential money creation that ain't happening. Something like this has not happened in the U.S. since the 1930's. If the fears of bankers subside and they start creating new money, the Fed can reverse QE by selling their holdings of Treasury bonds and reducing the excess reserves.

A similar QE happened during a banking crisis in Sweden during the 1990's. When normalcy started to return the Sveriges Riksbank, the Swedish version of the Fed, put QE in reverse and wound the whole thing down without inflation.

Finally, inflation is low. Inflation is below the Fed's target rate of 2%. Yes, some commodity prices are rising but that is due to the increased demand from China and other emerging economies that have expanding economies right now.

Is anyone still with me?

There are a lot more scarier things out there than the dollar not being the world's reserve currency. And even if there are:

"Peace I [Jesus] leave with you; my peace I give you. I do not give to you as the world gives. Do not let your hearts be troubled and do not be afraid" (John 14:27, NIV).


Parag said...

Quantitative easing in US is aimed at funneling more of the assets owned by the middle class into the pockets of the lower class and the financially elite class. QE is aimed at impoverishing Main Street in order to enrich Wall Street and its Prime Dealers.

RB said...

Hmmm... buying $600 billion in bonds is just a scam to get commissions to brokers? That is a new one. What's in it for Ben Bernanke? How does it get $$$ to the poor? I must be really missing some connections here.

Philippines Nightlife said...

well, you won't have to wait long to find out. Russia and China just recently moved away, and they are the "US and UK" of the east, so others will follow. it is only the matter of time.