Sunday, October 5, 2014

Michael Pettis — Are we starting to see why its really the exorbitant “burden”

This may be excessively optimistic on my part, but there seems to be a slow change in the way the world thinks about reserve currencies. For a long time it was widely accepted that reserve currency status granted the provider of the currency substantial economic benefits. For much of my career I pretty much accepted the consensus, but as I started to think more seriously about the components of the balance of payments, I realized that when Keynes at Bretton Woods argued for a hybrid currency (which he called “bancor”) to serve as the global reserve currency, and not the US dollar, he wasn’t only expressing his dismay about the transfer of international status from Britain to the US. Keynes recognized that once the reserve currency was no longer constrained by gold convertibility, the world needed an alternative way to prevent destabilizing imbalances from developing. 
This should have become obvious to me much earlier except that, like most people, I never really worked through the fairly basic arithmetic that shows why these imbalances must develop.…
China Financial Markets
Are we starting to see why its really the exorbitant “burden”
Michael Pettis | Professor of Finance at Peking University’s Guanghua School of Management

15 comments:

Ryan Harris said...
This comment has been removed by the author.
Dan Lynch said...

It seems to me that there are both advantages and disadvantages to the dollar being a reserve currency.

The obvious disadvantage is that it seems to inflate the relative value of the dollar, which hurts American manufacturing jobs.

Reserve currency status may be an advantage to America's financial sector, and may partially explain why that sector has become so big and powerful? However, it's not clear that the bloated financial sector benefits the average American?

Another advantage to reserve status is that oil is sold in dollars, although that is partly due to the semi-secret 1976 Doha agreement between Kissinger and the Sauds.

It may be a chicken or egg question -- is oil sold in dollars because the dollar is a reserve currency, or is the dollar a reserve currency because oil is sold in dollars?

Getting a little off topic, I wonder if the dollar is truly a floating currency, since it is effectively pegged to the price of oil? One can make the argument that since leaving the gold standard, the US has effectively been on an oil standard, with the Sauds agreeing to stabilize the price of oil as per the Doha agreement. It's a strange way to manage a currency.

If the dollar loses reserve status:

-- price of oil may go up in the US, depending on whether the Sauds stick with the Doha agreement

-- the dollar would devalue which would greatly benefit US manufacturing

-- Wall Street might lose some business and clout. (I would not shed any tears for Wall Street).



Ignacio said...

"What is less clear is what will happen internationally as the US stops producing a sufficient stable supply of deficits/debt/savings destination for the external sector."

The beggar-thy-neighbor policies of Germany, Japan, and lastly China are coming to an end (although China policies are payback for the British favours of the opium wars a century ago, and rightly so). But it's the natural consequence of a more multipolarized world. We will have to face a terrible desinflationary/deflationary age through the 'aging' (developed) nations, eventually the hard money crowd will have to give up and print and we will see an expansion of government with an ever rising quota of the economy while there is an increase in fringe black market economy, all these characteristics of a command economy. It will be that, or it will be chaos and anarchy (which the hierarchy will never allow). Probably a mix of both along with increasing wars and violence all around the glove.

Unfortunately the disgraced people that created this situation and wasted one of the most prosperous times of our species will not live to see the chaos they have created in its plenitude, but they will bash us daily wit their stupidity about "how are we going to repay the (fiat) debt" until they die. May they RIP.

Jose Guilherme said...

Condition 2) certainly does not apply.

The U.S. had persistent current account surpluses from the end of WWII to the late 60s - and in this 25-year period the U.S. dollar was the world's reserve currency par excellence.

Unknown said...

"eventually the hard money crowd will have to give up and print and we will see an expansion of government with an ever rising quota of the economy while there is an increase in fringe black market economy, all these characteristics of a command economy."

Why do you think all of that will happen?

Ryan Harris said...

Good point, Jose. Something to think about. Banks were replaced by government and credit markets as primary sources of credit during that period. I'm not sure they are connected though without seeing the data on flows. It was a very atypical period. Like Japan in the 70-80s or China in the 90-00s where consumers levered up and took the reigns from industry as drivers of economic activity.

I deleted my comment anyway because it was too meandering and long.

Ignacio said...

"Why do you think all of that will happen?"

Cause that's what usually happens in periods of harsh deflation, when poverty increases and is widespread, and the political system is in danger of revolt, usually to counter a collapsing society.

Nothing new really, already happened in developed nations in the first quarter of the XX cent and has been happening all over the place until recently in South America (but for different reasons). Or maybe TPTB can engineer a 'soft land'. but Japan has barelly managed until now with a very favourable international economy (until a few years ago) and exporting deflation to the rest of the world, but the scenario has (is) changed now.

Jose Guilherme said...

Thanks, Ryan.

In fact, current account transactions are only a tiny portion of total transactions between countries - the bulk of monetary transactions is to be found in the financial account of the BoP, not the current account.

So, it´s perfectly possible for a country to provide the world´s reserve currency while simultaneously keeping a surplus in the current account.

The country in question will simply have to provide the necessary amounts of the reserve currency in different ways - for instance, by lending massively to foreign entities, preferably at low interest.

Also, in the case of the U.S. (and maybe, who knows, of China tomorrow) there is also the very convenient eurodollar market. A foreign bank headquartered in Europe with dollar accounts in the U.S. banking system can then expand its balance sheet by multiples of 5 of 10x with loans denominated in dollars.

These dollars are not technically part of the U.S. money supply but they serve as a neat source of financing for (trillions of $) international transactions denominated in dollars.

It´s high time for dropping the incorrect meme according to which having a current account surplus would be a necessary condition for a country to provide an international reserve currency.

Ryan Harris said...

Financial stocks are built from current flows over time though and once stocks are levered up, even a second derivative change can have an outsized impact. An overall change in the direction flows can begin to reduce stocks, and we all know what happens then.

I sort of think that is why the value of the dollar has these herky-jerky panic rallies as the US reduced it's current account deficits and at the same time ended QE or during 2008 when credit dried up. Within reason, an excess of dollars isn't ever a problem, but a severe shortage can only be alleviated by more dollars or a new substitute reserve currency. Look at the charts on the eurodollar futures, the fed has lost control several times in recent years. Their new policy to use repos to meet target rates is not much better, it is like having breaks but no accelerator. They can remove dollars from the system but they can not add.


Assume the current situation where China is pegged to the US dollar and has levered up their system with stocks of non-sovereign financial debt of 13 trillion, they've grown accustomed to increasing their USD$ reserves by what 10-15% a year, then the United States reverses course, stops importing as much, reduces the availability of dollars to the external sector. If China wants to continue to peg to the US dollar, they have to?
At the same time, Brazil, Turkey, India and others are clamoring for dollars. And the Saudis, Singapore, Norway have all converted most of their reserves out of currency, to treasuries in past decades, then out of treasuries into real estate and stocks and corporate bonds in recent years and need the treasuries and hard currency they have for their own needs so they can't provide them to markets during crisis. The entire reserve system is levered up. US banks have been limited by regulation from speculating or trading, so they can't really help provide liquidity during crunches anymore either...
Unlikely to happen, but the market risk is for a disorderly dollar rise, not for a dollar collapse like the gold bugs talk about.

Tom Hickey said...

I found it an excellent comment, as are all the comments you post here, Ryan. It would make a good post in itself.

The period in which the US was both issuing the global reserve currency and running surpluses corresponds roughly to the les trente glorieuses (1945-1975), which Piketty points out was an uncharacteristic time owing to global conditions. It ended for the US with the realization that the US could have fight a war and create The Great Society simultaneously. So perhaps period this can be viewed as an atypical blip.

While the wind down was gradual, the ending was abrupt with Nixon shutting the gold window in August 15, 1971, and the negotiation of a new monetary system agreed to in August 1973, which substituted a floating exchange rate instead of a fixed rate based on the $/oz exchange rate of the USD and gold by the US. It was clear then that a fixed rate was too restrictive a constraint on policy space. This set the stage for the neoliberal era that was to unfold subsequently, which emphasized free markets, free trade and free flow of capital on the assumption that markets are self-correcting. That hasn't worked out so well.

There is always some price anchor that currencies can be compared against and petroleum as been the commodity of dominant importance so it is a reasonable standard to use. I think that the fact that oil is traded in USD is highly over-exaggerate though, since it is simple to convert one currency into another and to hedge with future contracts.

Carbon-based fuels are going to become less competitive against renewable technologies now being scaled anyway. More relevant is using a unit of energy as a standard, as Chris Cook proposes, since energy is the fundamental real economic unit, while currencies are merely used for scorekeeping. Currencies are relative to each other and what actually counts is PPP.

Roger Erickson said...

"the world need[s] an alternative way to prevent destabilizing imbalances from developing"

?? It has it. The floating-Fx-exchange-rate system.

That's the whole basis of markets - and biology and ecology, if you think about it.

All we need to get rid of are the many incentives for excess local hoarding, instead of growing human enterprise. Our greater store of net (dynamic+static) survival value is in our capabilities, and NOT just in the static commodities we excessively hoard.

An adequately-connected system does not care overmuch what local arbitrages arise in order to drive net return-on-coordination.

What is the "value" of a given ATP-molecule in one part of the cell vs another one? Depends on how much demand there is for one "transaction-chain" vs another one. In biochemistry the jargon is sinks & sources, not absolute "value."

Similarly, what is the "value" of two eggs w toast, or a cup of coffee, or a $1, in say, an oil-field work camp, a proverbial mining town, your corner cafe, or a bistro on Wall Street? Reality is that we end up doing things the proverbial "right ways," the proverbial "wrong ways" and then the proverbial "army way" [or civic way] - in order to build dams, highway systems, NASA, local/state/federal Congresses .... you name it (including wars).

When distributed feedback networks allow distributed feedback to flow as fast & far as needed, WHEN it is needed ... then the quality of distributed decision-making allows all parts of aggregates to make decisions which simultaneously arbitrage local, regional, national, global Desired Outcomes, based on immediate, short-term and long-term process expectations.

That's how "fiat" systems work. Currency is, after all, just another form of information.

How do we always prevent destabilizing decision-cycles? We set up ways to get enough feedback between all components needed to tune ongoing processes. We'll find a way.

There'll be an app for it. :)

hint: Physiologies have an "autonomic" or visceral nervous system as well as a "somatic" (navigation) nervous system. The exact division is, of course, arbitrary, but the point is that our national culture lacks something as rudimentary as an autonomic-cultural-nervous system.

Mosler's ongoing point is right on. We need MORE Automatic Stabilizers. Plus, they should ALL be considered as "Off Discretionary Budget." You, know, to manage a nation, first keep all the "cells" alive, healthy, and functioning in their optimal operating zones. (the citizens, that is)

Tom Hickey said...

Floating rates only work as advertised if they exist in an environment of economic flexibility. As Pettis points out, governments game the system, which is what contemporary mercantilism as practiced by China and Germany is about. It's also an issue wrt the developed world and the emerging world. In any case, it is the weaker that pay for the stronger by lowering the living standard and raising unemployment, as well as private debt. In the end, either private debt is converted to public debt or else the creditors holding the loans find their own balance sheets threaten due to non-performing loans or default.

This is the problem with neoliberal solutions, like free trade, that assume flexible adjustment of nominal values to real foundations, assuming money as a neutral veil. But in monetary production economies dependent on credit and debt and with large financial and business interests, weak labor, and crony governments, it doesn't work that way.

Roger Erickson said...

Agreed Tom, but those are all coincidental to constantly re-sampling distributed feedback and re-testing distributed implications - i.e., exploring aggregate options.

There's always a further step between inventing a new method, and learning when and how to use if adaptively.

Bruised thumbs attest to that, but are not an adequate reason for humanity to stop using hammers.

Tom Hickey said...

The question is how to fix a broken system that is resulting in systemic dysfunction globally. This brings up the question as to whether the issue is in the design or spanners in the works. We know that there are spanners in the works, but that doesn't mean that the systems design is optimal either. It doesn't seem to be if it allows participants to throw spanners in the works. It does no good to say that the system is fine (ideally) when practically its not working as advertised.

For example, it's difficult to game a gold standard for international trade, which is why some favor it. But it also limits policy space, on one hand, and likely, limits trade on the other.

The question is developing a system with maximum policy space, as much trade as possible, and game proof.

We aren't there yet, and we won't be until economists start thinking chiefly in terms of a global economy as a closed system instead of a set of competing nations with open economies. The later leads to seeking competitive advantage, often at the expense of others. This is a recipe for dysfunction, and pressure to return to a fixed rate system in which currency is exchangeable for a real asset like gold.

Roger Erickson said...

Tom: "We aren't there yet, and we won't be until economists start thinking"

That's a rather constrained way to put it.

I'd rather say that "We aren't there yet, and we won't be until citizens start thinking about dynamic systems, instead of letting 'economists' try to think for them."