Exorbitant Privilege vs Pushing On A String: The Decline Of The Dollar

by Mike

Help! I’m shrinking!
(Graphic: Global Fund Exchange Blog)

It can’t happen here; We’re too big (to fail?); The whole world wants Dollars; We could never become The Weimar Republic/ Zimbabwe/ Greece/ 1960s Britain… After all, OUR financial wizards are too smart to let that happen!

Not so much! Just because Ron Paul has been telling us for a long time that the Federal Reserve was bad for us, doesn’t mean he’s wrong. Let’s check a few bullet points, and then I’ll explain why the warning signals are flashing a little more urgently these days:

1) Exorbitant Privilege – As the purveyor of the World’s reserve currency, the supposedly stable store of value, we get to print more whenever we need it, or the world demands it: Too much of the former, recently.

2) Pushing on a string – Originally coined by John Maynard Keynes, he of the government stimulus mindset, this describes what happens when further Federal Reserve easing does not increase the amount of loans being made to individuals or businesses. Could also describe what happens if we keep printing, and the World stops taking our Dollars.

3) Exporting Inflation – As long as the world keeps soaking up our printed Dollars for their goods, we don’t feel the increase of money supply so badly at home, but places like China feel severe inflationary pressures from converting that inflow of Dollars into Yuan (Renminbi).

4) Currency wars – What happens when nations get into a devaluationary spiral, trying to get a competitive edge on each other. There are signs that it’s happening, indeed accelerating.

5) Currency wars part 2 – Germany is repatriating its gold reserves while China, and probably Russia, are buying up gold steadily. What do they have in mind?

6) Buying more of our own debt – The Fed is buying up to 90% of US government bonds, potentially more than $1 Trillion added to the money supply every year.

Exorbitant Privilege
This is the blessing and the curse of being the supplier of the world’s primary reserve currency. As of last year, when The Economist published an excellent article on the topic, the Dollar accounted for 60%, or about $6 Trillion of the world’s currency reserves, IE the foreign currency and hard assets that a government holds to support the value of its own currency, and about 85% of the international trade settlements.

The curses are twofold: First, as world trade grows, more of the reserve currency is required as the liquid medium of exchange for that growing trade. Second, the temptation of the purveyor of the currency to just print more to satisfy a balance of payments deficit or government spending. These two curses came to a head in the Nixon Administration as the volume of Dollars required for world trade outgrew our gold reserves, and heavy spending on Vietnam and government programs required the printing of excessive amounts of Dollars. The world caught on, and Nixon severed the Dollar from Gold before Fort Knox was emptied out.

And still we print, the number of Dollars per ounce of gold is at record highs, yet other currencies are (for now) considered riskier, and the world still runs on Dollars.

Pushing on a string

H/T Andy Gale’s blog

It’s an old saying, which was first associated with the world of finance during FDR’s term, and attributed by many to John Maynard Keynes. It very eloquently expressed the futility of continuing to apply fiscal stimulus if the demand wasn’t there. As the cartoon nicely expresses, Bernanke doesn’t get it!

Pushing on a string also neatly encapsulates what will happen if the world stops demanding Dollars: Right now, the Dollar is the preferred currency for international trade, as well as for individuals (and governments) to stuff under their mattresses when the local currency is in crisis. This requires trust – trust that we won’t inflate away the value of their Dollar holdings; trust that we will pay our bonds that they purchased when we bought their goods with printed Dollars; trust that we won’t actually behave like Weimar Alan (Greenspan), who famously said “We can always print money to pay our debts” – yeah, that really worked out well for the Weimar Republic, didn’t it!

What happens when we print ‘em but the world doesn’t take ‘em? You think oil prices are bad now? Wait till it takes wheelbarrows full of trillion dollar coins to buy each barrel!

Exporting Inflation
Two years ago, WSJ printed an article describing how loose monetary policy in the USA causes hot money outflows which overheat the markets of our trading partners.

As they told it, the loose money policy does not show up immediately as inflation at home – First, it shows up as increasing prices of commodities traded at auction, or on the ‘spot’ market – Oil, Coffee, Wheat, Copper, etc.

Throwing money from a heicopter, now with GLOBAL impact!

Second, it shows up as inflationary pressure in the markets of our primary trading partners – here’s how: Any Dollars that, say, China takes in trade for goods have basically three places to go – Back to the USA as investments or bond purchases; in trade with raw materials suppliers; or into China’s currency reserves. As the amount of currency reserves held by a country rises, it ‘hardens’ their currency, driving up its value, for which the only quick fix is printing proportionately more of their own currency to maintain a balance, which causes inflation in their domestic markets. So now, ‘Helicopter Ben’ is effectively dropping money from the sky, GLOBALLY!

We accuse China of being a currency manipulator, and yet they have far more reasons to be upset with us, as they get 10% inflation from our folly, while we (apparently) get away with about 2%.

Currency Wars
Currency wars occur in a variety of ways. One of the seemingly innoccuous forms they can take is competitive devaluation, whereby one country tries to temporarily suppress imports and goose exports by cheapening its currency relative to others. In the days of Gold standards, or during the fixed exchange rate heyday of the Bretton Woods agreement, this was performed by declaring that one’s currency was now lower in value, and a greater amount of it would be required in exchange for an ounce of gold or a US Dollar. Aside from importing misery and causing domestic inflation, cheapening a currency does not have a lasting impact, but it remains a popular quack remedy amongst politicians. The Russians are warning of a possible currency war, and a report in ZeroHedge.com states:

[T]he rolling ‘beggar thy neighbor’ currency strategies of world central banks are gathering pace. To wit, Bloomberg reports that energy-bound Russia’s central bank chief appears to have broken ranks warning that “the world is on the brink of a fresh ‘currency war’.” With Japan openly (and actively) verbally intervening to depress the JPY and now Juncker’s “dangerously high” comments on the EUR on Jan 15th, it appears 2013 will be the year when the G-20 finance ministers (who agreed to ‘refrain from competitive devaluation of currencies’ in 2009) tear up their promises and get active. Rhetoric is on the rise with the Bank of Korea threatening “an active response”, Russia now suggesting reciprocal devaluations will occur (and hurt the global economy)

‘Beggar thy neighbor’ policies of a different type (tariffs) were part of what made the Depression Great.

Buy the book, and experience currency war gaming

But competitive devaluation is chicken feed to the kinds of storm clouds that are gathering. The Dollar is clearly weaker in terms of commodities than it was a few years ago (thanks, Fed). We have a huge risk if the world ever loses confidence in the stability of our currency, or if other, more stable competitors emerge. The Germans have always loved hard money, and are repatriating their gold reserves from Paris and New York; the Russians appear to be building up gold stocks; the Chinese are mining plenty of gold, but are buying, not selling, on the world stage.

It’s quite common for central banks to work in concert to stabilize a currency – preventing the Yen from rising too much, or the Pound ffrom sinking too low, but what if actors unfriendly to the USA, backed by large gold reserves, were to act in concert to dump Dollars, promote a basket of their currencies, and to turn the worldwide demand for Dollars on its head overnight? What if we pushed on the string and no-one was pulling? Read the entirely too believable “Currency Wars”, and I guarantee you’ll lose sleep!

Buying More Of Our Own Debt
As I mentioned earlier, one of the ways our trading partners can recycle those freshly ‘printed’ Dollars is back into US assets, but paradoxically, even though our government is borrowing like crazy, there is a shortage of Treasury bonds for purchase. In his desperation to pump life into our comatose economy, and keep interest rates at rock bottom, Helicopter Ben is buying about 90% of Treasury bonds, or put another way, adding about $1 Trillion of new Dollars to the world economy per year, without regard for the possibility that the tension on our piece of string will go into reverse!

Conclusions
I’m not a financial advisor, and I can’t tell you that you should switch your life savings into silver or gold, or bullets for barter, but there’s enough here to have me worried that Cloward and Piven are running the country, and that we should be prepared for trouble.


The warning signals are flashing!

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