The Dolla’ Makes Me Holla!

An article I wrote a while back on U. S monetary policy and the international economic system.

The United States Dollar has held the position of the world’s reserve currency since the implementation of the Bretton-Woods System after the Second World War. Many pundits and other Very Important People Who Know Stuff have often used the term “dollar hegemony” to describe this situation. Currently, two-thirds of the world’s foreign currency reserves are currently held in dollars, and nearly half of international foreign debt securities are held in dollar-denominated assets. Simply put, the U.S dollar is the world’s primary reserve currency. As such, the United States is able to exert a high influence on international financial markets and gains other economic benefits— in other words, “Dollar Hegemony” = Good. However, there is evidence that suggests dollar’s status as a reserve currency is being slowly and systematically diminished. So, this article suggests—ever so sweetly—that in order to maintain the U.S led global economic order and the benefits we receive from it,  our nation’s policymakers must take concrete and substantive action in order to maintain economic supremacy. Ultimately, the “economic order” which governs  growth and development must change to reflect the ever-changing international economy. We don’t seek to do away with the Washington consensus, rather we seek to modify it.

What are these mysterious reserve currencies you speak of?

Countries all over the world hold financial reserves in the form of bonds or money mark instruments denominated in some other currency. Reserves help a country do many things like conduct monetary policy. Nations also hold gold and often Special Drawing Rights issued by the International Monetary Fund. If a country is in poor financial state, international speculators might sell their own holdings of the country’s currency. This will depress the value of this countries’ currency and will result in negative economic impacts. If a country has foreign reserves, it could buy its own currency and sell its foreign currencies to pay for purchases. A currency, which is backed by substantial reserves, is stable and secure. For this reason, most countries are heavily invested in foreign exchange reserves.

The U.S dollar is the most common currency for international reserve because the market for dollar-denominated securities is deep and liquid—treasury securities can be sold quickly, which in a hypothetical financial crisis could help a foreign nation avert disaster. In addition, a substantial amount can be sold or bought without drastically affecting its price; so the value of the bond is not volatile—it won’t shoot up or fall. All in all, the dollar is quite a stable currency, making it an attractive reserve currency, which explains–partly— why even after the fall of Bretton-Woods and the Nixon shock, the U.S remained the world reserve currency.  However, if our country defaulted on its debt, or if our credit was further downgraded, the price of U.S Treasury securities would decrease, since they would be perceived, and rightly so, as more unstable. Why would a country hold a bond or a security if the country which issued the bond is not likely to pay back the money that they borrowed. So, countries would prefer to hold their reserves in another, more valuable asset.

So what’s in it for us? ( Read in the voice of an Italian mobster)

In order to understand why maintaining dollar hegemony is so important, one must first understand the benefits the United State’s gains from it. The dollar’s status as the world reserve currency triggers substantial demand for our securities—foreign countries hold about thirty percent of United State’s debt. Without this demand for United State’s treasury bonds, the interest rate the U.S. Treasury pays would be significantly higher causing private-sector borrowing costs to rise as consumer and corporate debt compete with public debt for investor’s holdings—i.e “crowding out.” Thus, among many many things, the dollar’s status keeps United State’s interests rates low.

Interest rates, on a very basic level, can be understood as the “price” of money. It is the price a borrower pays for the use of loaned money. The rate is represented as a percentage of the principle amount of money borrowed. If interests rates are high, borrowing money would be expensive, and individuals would be discouraged from lending money. However, if interests rates were low, individuals would be encouraged to lend and borrow money. By keeping interests rates low, the dollar’s status as the world’s reserve currency ultimately promotes growth and financial security within the United States. If the Dollar would lose this status, there would be massive inflation, higher interest rates, substantial increases in the cost of food and gasoline, and it would be much more difficult for the United States to finance its debt.

Our Current Situation

Despite the fact that the greenback has long been considered a stable and secure currency, it has become ever more apparent to economists worldwide that the dollar’s domination of international currency reserves is coming to a conclusion. This is representative of and a result of an international rejection of United States economic policy. Policies, that are based on the philosophy of market fundamentalism, the idea that free markets, naturally provide the most efficient outcomes. This economic philosophy was popularized during the Clinton administration, in which policymakers dismantled Depression-/era financial constraints. However, current foreign interpretation like that of Beijing states that this new policy created a “Washington-Wall Street” environment of unsupervised securitization in which the U.S. financial sector became larger, more concentrated, and riskier. From 1980—/2002, U.S. manufacturing fell from 21 percent of GDP to 14 percent, but finance (the biggest and fastest growing) increased from 14 percent to 21 percent. It is this risky and unconstrained growth, which foreign nations believe will continue undermine the security of dollar denominated assets. However, certain economists and politicians have claimed that a different macroeconomic factor is responsible for the decline in the dollar’s power. They find that the FED’s policy of Quantative Easing artificially cheapens the dollar, and reduces its purchasing power. This reduction in the active purchasing power of the dollar is, they claim, the reason for the decline in the dollar’s power. This view centers around one basic belief: that foreign countries are using other currencies because of this reduction of power. However, foreign nations have repeatedly stressed that the reason for utilizing alternate reserve currencies is due to their mistrust of American monetary policy and the doubtfulness concerning the stability of the dollar. It is not the reduction in purchasing power caused by Quantative Easing which in turn causes the diminution of the dollar’s power, but the instability Quantative Easing causes.

Evidence for the decline of the U.S dollar’s power is as follows: China and Japan have struck a deal which will promote the use of their own currencies (rather than the U.S. dollar) when trading with each other. The second reason was taken from the magazine, The Economist, “The five major emerging economies of BRICS — Brazil, Russia, India, China and South Africa — are set to inject greater economic momentum into their grouping by signing two pacts for promoting intra-BRICS trade, which will enable credit facility in local currency for businesses of BRICS countries.” The BRICS countries will shift from utilizing dollars in trade to using their own local currencies. Thirdly, China and Russia already use their own currencies when trading with each other. Furthermore, the United Nations and the IMF continue to push for a new reserve currency. A UN report stated that, “the international community envisions a new global reserve system…that no longer relies on the United States dollar as the single major reserve currency.” U.S power is facing new macroeconomic constraints that derive from a basic and generally underappreciated shift in U.S. engagement with the global macroeconomic order.

What to do, then?

Even if one does not accept the opinion that current policy is flawed, foreign countries perceive that it is. This opinion, will lead to the diminution of the dollar’s influence. States will start to have divergent preferences about the global financial order, something that will reduce U.S. influence, making cooperation on the governance of money and finance more problematic. In particular, many states will search for ways to insulate themselves from the dangers of unmediated global finance. It is the responsibility of United States politicians, economists, and the FED to craft international and domestic economic policies, which will reaffirm the credibility of the dollar as a stable and effective reserve currency.

The FED must first gradually phase out its policy of Quantative Easing. Quantative Easing seeks to keep interest rates low by having the Fed change the composition and sometimes the size of its balance sheet. Renowned economists Paul Krugman explains,” To think of Fed policy in our current situation, once can imagine a financial equilibrium in which there are three assets: short-term Treasuries/monetary base — which are equivalent and yield an approximately zero rate of interest; long-term Treasuries; and mortgage-backed securities. There are two interest rates that clear the markets — the rates on Treasuries and MBS (the third rate is fixed at zero).” In this situation, to boost the economy the fed must reduce private-sector borrowing rates by swapping short-term assets for MBS (mortgage backed securities). However, the FED currently has been buying long-term treasuries. This should theoretically indirectly reduce interest rates on MBS, however in practice this reduction is not adequate enough, and does not function effectively as a policy.

Some Sources:

http://econlog.econlib.org/archives/2013/10/the_relative_un.html

http://www.forbes.com/sites/billconerly/2013/10/25/future-of-the-dollar-as-world-reserve-currency/

http://ipsnorthamerica.net/news.php?idnews=1713

http://www.munknee.com/shift-from-u-s-dollar-as-world-reserve-currency-underway-what-will-this-mean-for-america/

http://www.economist.com/node/16064067

http://www.federalreserve.gov/monetarypolicy/openmarket.htm

http://www.beaufortobserver.net/Articles-NEWS-and-COMMENTARY-c-2013-05-29-267125.112112-US-dollar-losing-ground-as-worlds-reserve-currency-What-does-that-mean-to-your-children-and-grandchildren.html

http://www.economist.com/node/16064067

http://www.dailywealth.com/2416/dollar-usd-world-reserve-currency

http://seekingalpha.com/article/1731772-government-shutdown-threatens-u-s-dollar-world-reserve-currency-status

http://business.financialpost.com/2013/10/15/us-dollar-supremacy-decline/

http://www.humanevents.com/2013/10/14/how-much-longer-will-the-dollar-be-the-worlds-reserve-currency/

http://www.nber.org/papers/w11336

http://articles.economictimes.indiatimes.com/2013-10-16/news/43107179_1_reserve-currency-treasury-bonds-debt-ceiling

http://internationalinvest.about.com/od/foreigncurrencies/a/What-Is-A-Reserve-Currency.htm

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