Saturday, August 23, 2008

Mortgage Crisis, the Dollar and its Future, Part 3

The Fed, of course, hopes to pick the optimum rate for increasing the money supply, but it will always prefer to err on the side of being a little too loose rather than a little too tight. Everyone on the Fed board is aware of the role of tight money during the Great Depression and wants to avoid a similar outcome at all costs. The danger of just a little more inflation will always seem preferable to the risk that an economic correction will slide dangerously further than expected. The latter can pose a far more difficult problem for the Fed. The leverage which was so attractive to investments on the upside now works in reverse, accelerating the decline. Sharp losses in the stock market, real estate and elsewhere can be wipe out assets rapidly on a colossal scale that monetary policy cannot quickly replace. Moreover, the Fed can make credit available, but it can't make people use it. It's actions have been compared to “pushing on a string.” People have to want to “pull” on the available credit for the Fed policy to have effect. When an economy gets so bad that pessimism pervades society, businesses are afraid to hire new workers or invest in plant or equipment, and consumers are afraid to spend. Then central bank policies are ineffective. A case in point is Japan after the collapse of its stock market in 1989. During the 1990s, even an interest rate as low as zero couldn't revive the economy. The country still has still not fully recovered. Its stock market (Nikkei Index) is barely one-third of its peak in 1989. Trillions of dollars (or yen) of assets were wiped out that have never been recouped.

Another factor favoring continued inflation in the U.S. is the growing national debt, which has accelerated wildly under President George W. Bush. Congress increased the debt limit five times since he took office in January 2001. At that time, the national debt stood at $5.6 trillion. Now it is $9 trillion. The $3.865 trillion increase is the largest of any administration ever, despite the fact he ran for office as an economic conservative.

A growing portion of our national debt is held by foreigners, particularly foreign governments. Foreign investors own only about 13 percent of U.S. equities but 44 percent of U.S. Treasury debt. And it is likely to get worse. As Peter Orzag, director of the nonpartisan Congressional Budget Office, recently testified on Capitol Hill, “Under any plausible scenario, the federal budget is on an unsustainable path—that is, federal debt will grow much faster than the economy over the long run.”

Our government finances its deficits by auctions of U.S. Treasury securities. It deposits the proceeds from the sale of the securities into it own checking account, against which it writes checks for employee salaries, federal contracts, government grants, goods and services.. The recipients of these checks deposit them in their own accounts at commercial banks. Those banks then are required to set aside a percentage (currently 10 %) as a reserve—but can loan out the remaining 90 %. For example, if someone receives a government check for $1,000 and deposits it in his bank account, his bank sets aside $100 as the required reserve and can then loan out the other $900. When someone else borrows that $900 and deposits it in his account, his bank sets aside $90 and loans out $810. The next time around, the amount loaned out will be $729. The cycle repeats until there is nothing left to loan. At that point it will be seen that the total amount of deposits is $10,000, which consists of the original $1,000 plus $9,000 in credit created by the banks. That's how the increase to our money supply can be ten times the amount borrowed to finance our debt. Is it any wonder we have price inflation?

It should be noted that the ten-fold increase in the above example increases the money supply only when treasury securities are purchased by foreigners. If those securities are purchased by Americans, no new credit is created, because the money that the government receives has already been part of the U.S. money supply; it is simply transferred from the private sector to the government, with the multiplier being the same for both. But when foreigners buy treasury securities, the proceeds are added to the previous money supply.

In 1971 President Nixon severed the last link between the dollar and gold by declaring that the U.S. government would no longer allow foreign central banks to redeem their dollars in gold. Prior to this, the dollar had been a “reserve currency” because of its gold convertibility, and foreign banks held their reserves in both dollars and gold. But as they accumulated more and more dollars, they knew the U.S. had nowhere near enough gold to back the outstanding dollars. So they wanted to get gold while they could. The U.S. paid out several billion dollars in gold but could not stem the tide of demands. It was obvious that further redemptions would soon exhaust our reserves. So Nixon simply declared that no more gold would be paid out.

The system of fixed exchange rates broke down, and currencies were set free to float against each other. But the dollar was still a reserve currency. Central banks had large quantities of them, and have been accumulating more. More than 60 % of foreign exchange reserves are still kept in U.S. dollars, which have been losing value rapidly. Priced against a basket of major currencies, the U.S. dollar has lost 38 % of its value in the last six and a half years. It lost 7.5 percent in 2007 alone. It lost 17 % last year against the Canadian dollar, falling to its lowest level in well over a century, and nearly 17 % against the Brazilian currency. It lost more than 10 % last year against the Turkish, Thai, and Indian currencies. And it lost 9.5 % last year against the euro, the common currency of 15 countries in the European Union. At one point in 2000, a dollar would buy 1.176 euros; now only .6250, a decline of more than 47 %.

Foreign governments are alarmed that the large and growing percentage of their monetary assets in dollars is rapidly losing value. They have been buying U.S. treasury securities, for which they collect interest, but the interest is clearly no longer keeping pace with the loss of value in the currency. So they are looking to reduce their risk and diversifying into assets that will better retain their value.

It is the oil-producing countries and China, with its rapidly growing economy, that find themselves with mountains of dollar reserves. The Persian Gulf nations originally pegged their currencies to the dollar to stabilize oil revenues, because oil was priced in dollars. But this forces them to accept U.S. inflation and monetary stimulus. It also makes their imports from countries with stronger currencies more expensive. Now the Fed is cutting interest rates to fight the slowdown in the U.S. economy. This policy is exactly opposite to the interests of the oil producers who are fighting inflation and overheated economies. An official spokesman for Qatar has stated that pegging its currency to the dollar has “many disadvantages, especially if that country adopts monetary policies that clash with ours." In November, Nasser al-Sulweidi, governor of the United Arab Emirates central bank, while acknowledging that the dollar peg has “served the economy...very well in the past” ended by saying: “However, we have reached a crossroads.” Kuwait severed its peg with the dollar in May 2007, linking it instead to a basket of currencies. Since then, its currency has strengthened about 5 % compared to the dollar.

Since oil is priced in dollars, the depreciating value of the dollar gives oil-exporting countries an incentive to try to keep oil prices high, by restricting production, to avoid eroding their own purchasing power. It also gives them another incentive to move away from the dollar, with the euro being the most attractive currency for pricing oil. Beginning in 2003, the oil price tripled in U.S. dollars but only a little more than doubled in euros.

Thus far Saudi Arabia, though it is struggling with inflation, has said it will retain its link to the dollar. Its foreign minister, Saud al-Faisal, said such a move would damage the U.S. economy. Other countries, however, are not so considerate of U.S. interests, because they do not have the long relationship that Saudi Arabia has with the U.S., which includes military protection. Russian President Putin, who has visions of restoring his country to its former stature as a world power, would be only too happy to advance his ambitions at the expense of the U.S. He would like to see the ruble become a global currency and has expressed interest in a Russian stock exchange pricing oil and gas in rubles. That is not realistic now—though Russia is the world's second largest exporter of oil—but in 2005 he severed the ruble's link to the dollar and aligned it with the euro.

Russia has $475 billion in reserves, but China has $1.7 trillion, with which it could do a lot of damage to the U.S. dollar if it so chose. Deng Xiaoping, who turned China away from Mao's communism, urged the country to “bide time” and “seek cooperation and avoid confrontation.” His successor Jiang Zemin had big ambitions for his country, but he continued Deng's approach because he saw the benefits of cooperation with the U.S. and its allies. Current President Hu Jintao has changed directions. In the words of China scholar G.G. Chang, he “appears to see his country working against the U.S.” (italics Chang's). Last year China refused to provide shelter for two U.S. minesweepers seeking refuge from a storm. In November, a long-arranged port call for the carrier Kitty Hawk was denied at the last minute. A routine flight to resupply the American consulate in Hong Kong was denied. Veteran China analyst Willy Lam has noted that Mr. Hu and the party leadership structure have decided “to make a clean break with Deng's cautious axioms and, instead, embark on a path of high-profile force projection.”

In October 2006 a Chinese submarine surfaced for the first time in the middle of an American carrier group. In January 2007, China “in an unmistakable display of military power,” said Chang, “destroyed one of China's old weather satellites with a ground-based missile.” Its military exercises last August “were remarkable in scope and sophistication” and were “apparently rehearsals to take Taiwan and disputed islands in the South China Sea.” Hong Yuan, a military strategist at the Chinese Academy of Social Sciences, says China's new posture shows it intends to project force in areas “way beyond the Taiwan Strait.”

So don't expect China to do us any favors in regard to the U.S. dollar. It will use its dollars against the U.S. when it considers it most advantageous to do so. It continues to fund our deficits by buying U.S. treasury securities because actions destructive to the dollar would also be destructive to its own hoard of dollars. That hoard, however, continues to lose value anyway because of U.S. inflation. As the value of the dollar continues to slide, not only China but other countries, too, will demand higher interest rates on U.S. treasuries to compensate for inflation. Those rates, in turn, will slow the growth of the U.S. economy, making us more dependent on foreign financing of our debt and at odds with our own monetary objectives for economic growth. As China's mountain of dollars grows, it becomes an ever more potent weapon to use against the U.S. at some future date. Meanwhile, China also seeks to mitigate its own growing risk by diversifying out of dollars.

To be concluded.

1 comment:

Ben said...

A very interesting insight into monetary matters and the "states of the nation and the world"