Wednesday, October 14, 2009

Why Does the World Need the Dollar?

Earlier this year, I wrote a lot about inflation, and whether or not it would occur. I now believe that the dice has been thrown, that there’s no turning back: there will be large-scale inflation soon enough. The reason: the U.S. has spent almost $12 Trillion in an attempt to re-inflate the economy artificially.

To put it bluntly, the U.S. economy should no longer be described as being on a “sugar rush”. A more accurate analogy would be a cocaine high. What else could account for a 60% surge in stocks while the real unemployment rate is 20%?

Related to this is the U.S. dollar. Inflation hurts the dollar, but that’s far from the whole story. The dollar’s future as the world’s reserve currency is at stake. If everyone who holds dollars or dollar-related assets abroad starts thinking that these dollars will be worth a lot less in the near future, there will be no alternative to a currency crisis.

The fact that the U.S. has the world’s reserve currency enables it to spend far more than it makes. As I have mentioned before, this is the reason why a lot of economists, and especially American economists, are of the mindset that macro-economic models don’t apply to the U.S.. I think there’s some truth to that, because if you don’t HAVE TO ever pay back your loans, you don’t really have to worry about them. However, what happens on the day that you have to start paying?

Some prominent economists, most notably Paul Krugman, are currently claiming that a weak dollar is good for the U.S.. This will help U.S. exports, the theory goes. Also, according to Krugman, the U.S. needs to spend money on stimulus to get the economy going again, in other words through Keynesian spending.

Krugman does not address the potential of the dollar losing its position as the world’s reserve currency, but instead focuses his analysis on the short-term perspective of fighting the crisis and unemployment at all costs. What he does not realize is how real of a danger this is, but I’m sure he realizes the consequences if this were to actually happen. That’s probably why he’s not talking about it.

I believe that it actually wouldn’t take that much for the dollar to lose its position right now. Under the surface, many important international economic players have been discussing replacing the dollar with something else. These players include both wishful thinkers and those who would actually be in financial danger in the short term. If a few of these players were to move away from the dollar, it might set off a chain reaction that could crush the currency.

First this spring, people like Vladimir Putin and Hugo Chavez started talking about the need for replacing the dollar, while barely being able to hide their excitement.

Second, shortly after that, the IMF started dusting off the old idea of international drawing rights, or a basket of currencies. This debate was also helped forward by Joseph Stiglitz and Simon Johnson, both formerly connected to the World Bank and the IMF.

Third, and this is one of the most important ones, China started voicing concerns about the dollar. This time, Geithner had to go to China and give a speech about how great the dollar was doing. China buys a third of U.S. debt on the international market.

Fourth, and this one might turn out to be very important too, Japan elected a new non-conservative government for the first time ever. Japan buys about the same amount of U.S. debt as China does. One of the basic premises of the new Japanese government was that it would stop trying to be the U.S.’s lap dog. We’ll see how that goes, but I don’t think we can expect to see Japan follow Geithner’s every whim.

Fifth, rumor has it that the Arab Gulf states want to get rid of the dollar too. Their incomes are down by more than half since the beginning of the crisis, and they’re getting a little desperate. For the dollar to drop drastically in addition would be disastrous for them.

All these economic players are not dumb, they understand, in contrast to people like Krugman, that there are some very real dangers connected to owning dollars at the present time. They may run the risk of losing their savings and day-to-day incomes at the same time.

The number one question then becomes: Why does the world need the dollar?

The dollar was instituted as the world’s reserve currency at a time when the U.S. was a world leader in production as well as consumption. This meant that the dollar was both “as safe as houses” and “as good as gold”. An advanced economy with a competitive industry would be less likely to resort to irresponsible fiscal practices, and an insatiable, highly materialistic American consumer could keep the smoke in the chimneys in factories around the world. In other words, the U.S. was the economic engine of the world, and that’s why it made sense to use the dollar as the reserve currency.

However, the U.S. is not in the same position either in terms of production or consumption, and definitely not in terms of fiscal responsibility. The American manufacturing industry is not competitive, and the American service industry turned out to be smoke and mirrors on Wall Street. There is no way that the American consumer is going to get back to spending the way they used to, because it was all built on credit.

I believe that there is a shift happening in the world economy right now. In terms of the future developments of the balance of power between the big three blocks, Asia, the EU and the U.S., this is how I think about it:

It is clear to see that China will only continue to increase both its sophistication and volume of trade. The recent crisis has only strengthened the country’s position. The U.S. is no longer China’s biggest trading partner, the EU is. Japan is also increasing trade with China, and so is India.

It seems that the EU will continue to do what it is currently doing: to be competitive in very advanced industries, while not growing or shrinking much either way. I’m basing this on a continued focus on industrial policies, a good access to education and in general a less volatile society.

With respect to the U.S., it is very hard to see what the country has going for it. Where is the growth going to come? What is going to improve? The country has no industrial policy, and will not get one soon. One year at an American University costs as much as a Mercedes E-Class. The political system is deadlocked by lobbyists who bribe individual politicians. Industry resistance to innovation digs the grave of American manufacturing. More importantly: the country is bankrupt.

I believe that the world economy will shift, and that the dependence on the U.S. will have to be lowered. This will mean more power for Asia, and a tighter relationship to that continent on the part of both the U.S. and the EU. This will also mean that the dollar will most likely be given up as the world’s reserve currency.

What will this mean for the U.S.? Simply put: a drastic reduction in material prosperity across the board.

Moreover, I advise that the winner-takes-all voting system should be destroyed.


wulfmankarl said...

Paul Krugman Admits the Real Reason he Likes Inflation - It will bring about an Egalitarian Utopia

Jacob said...

I don't know what that link is about. This is no place for conspiracy theories.

I support the creation of an egalitarian society, because I think it's a moral imperative, and a must in the modern world in order to remain competitive.

I do not, however, support total fiscal irresponsibility and short-term perspectives on anything economic, financial and political, which is the prevailing strategy always in the U.S..

Anonymous said...

Are you saying that the world will no longer have one reserve currency?

If this is so, then I think most people will start using the Euro because who wants to use the currency from a country where the rule of law doesn't really exist? (e.g. china, russia, India, etc, etc

Jacob said...

I think the most likely scenario would be that instead of just one currency, a basket of currencies will be used. The Euro would certainly be important in that basket, as would the Japanese Yen and the Chinese Yuan.

The basket of currencies would be handled by an international authority, such as the World Bank. In other words, the price of a barrel of oil would be denominated in this world bank reserve currency. So, a barrel would cost maybe 50 "World Bank Dollars".

Such a currency basket would likely increase integration and homogenization in terms of economic policies, which is another reason the U.S. is against this. The U.S. wants to keep the casino economy, which would be very difficult to do if the current situation changes.

Anonymous said...

As I see it the question whether the Dollar can remain as the world's reserve currence cannot be separated from whether the Dollar's role as "petro-dollar" remains.

There is a long standing agreement between the US and Saudi Arabia that the US will protect the Saudi regime from any military threats and Saudi will sell their oil in Dollars and in Dollars only. And further, Saudi will push for OPEC to do the same, and Saudi is THE OPEC-heavyweight, the one member with any significant swing capacity.

Iraq once announced that they'd sell oil in Euros. Shortly after Iraq was invaded. Now, I'm not saying that the invasion was a direct result of Iraq's decision to trade in Euros, but what is significant is that the decision was immediately reversed after Saddam was toppled.

It is THAT important. If it was announced that a currency-basket (or any competing currency for that matter, but a currency-basket is more likely) was to replace the Dollar as payment for oil, then there would be no reason to maintain the Dollar as the world's reserve currency and the Dollar's value would plummet over night.

But how likely it is that this might happen? No idea.

Marcus - Sweden

Anonymous said...

I wouldn't bet too much against displacement of the dollar as the petro reserve. It hasn't just been the Iraqis prior to the invasion who have chattered about changing their petro reserve currency. I seem to remember rumors and innuendo in the '90s about it, as well as even after September 11. I'll see if I can find legit links.

I laughed when I read your reference to the cocaine high, Jacob. It was particularly fitting since the party drug of choice among Wall Streeters in the '80s was cocaine. I don't think WS has ever come down, really.

In reference to Krugman, he does make some legitimate points--but seems to do so in a vaccuum, or at the very least from a position with blinders on. There hasn't been a healthy manufacturing sector in the States for decades in terms of exports, and I think the fact that we really have nothing in terms of economic strategies, goals, plans, etc., is what came to the forefront over the past two years.


Stephen said...

I don't think it's out of the realm of possibility that China and/or Russia would be more than happy to replace the US with their own long standing agreement(s) to protect the Saudi regime from any military threats. They are not currently involved in two military campaigns and have the resources to protect the Saudi's.

Both appear to be financially solvent as far as I know, and both have substantial armed forces as well as a shared economic ideology. Both have incorporated hues of Capitalism into their Communistic and Socialistic systems producing great wealth.

I am aware that China would have to walk a fine line as it is a holder of much of the US debt, so therein lies the twist for them. If this 1.3 billion person energy guzzling economy offers itself up to the Saudi's, it may offset their losses in terms of US debt. Unlike the US, China doesn't appear to be going green, just the opposite. That would appeal to the Saudi's.

Our system was doing fine until the faith and trust in it was shattered by banks with avarice and greed which now calls into question the validity of any ideas they may have on the world stage.

I see the future basket currency including the the unwanted stepchild.

Jacob said...

The discussion on Saudi Arabia is interesting. How good friends are they really to the U.S.? Needless to say, the cultural differences are... vast.

Perhaps they would be best described using a popular tweenie-term: "frenemy". Do they like Obama? Probably not. I hear people aren't too keen on black people in Saudi Arabia.

Recent reports show that Saudi Arabia has lost 65% of their pre-crisis income:

As far as I'm concerned, the financial Armageddon already happened to them.

If I were them, I wouldn't be afraid to try something new...

russedav said...

The Founding Fathers established a brilliant system. "US Parliament" fools lust after a bogus delusional alleged utopia only the blind would want, one that could never be created, much less survive, denying human nature as it does, as the Founders knew painfully well from their lack of the denial of man's wickedness needing God as their savior, overwhelmingly present today. The Biblically and historically illiterate running our country will destroy it, as they warned, knowing Christians to be indispensable for leadership.