Sorry, that’s a cop-out. There will need to be a currency to replace the dollar if it is no longer the world reserve currency.
The world financial system will not function without a reserve currency. The central bankers of the world know this, the Arab oil kingdoms know this, the ChiComs know this. There’s no way out of the requirement for a reserve currency in the world.
So, here’s the choices:
1. The dollar.
2. The Euro.
3. The Yen.
4. The Yuan.
Of all of these, only 1 and 2 are liquid enough to be contenders. The Yen isn’t quite there yet, and the Yuan has serious issues.
OK, so let’s talk about the Euro: As everyone suddenly discovered this October, while the US banking system is pretty screwed up, the banks in the EU are more screwed up, more highly leveraged. Further, everyone discovered the Achilles Hell of the Euro: the Euro is a currency without a single sovereign behind it. It has a dozen or more sovereigns behind it — and when the crap hits the fan, all of the sovereign treasuries behind the Euro go running back inside their own borders, protecting their own interest first and screwing their neighbors in the process.
The Euro is, therefore, now out of the running for being a reserve currency. No one can trust the Euro or the EU member nations any more. And quite frankly, whatever ill befalls the US will blow up Germany rather hard, which will cause the foundation of the Euro to totter. As you said, foreign countries selling goods into the US are going to suffer. Well, the Germans are the biggest exporters in the world, and they depend critically upon exports to the US.
I read the German business press (in German) and here’s the executive summary of what they’re saying amongst themselves:
“We’re so screwed.”
As to the Yuan: Ain’t gonna happen. No even remotely in the running for reasons that no one really trusts the ChiCom’s accounting. They’re flat-out lying about what is going on inside their own banks, their government plays a unified game with fiscal and monetary policy, and games both to maximize their exports to the US, not to maintain a stable currency. Their currency is currently a soft peg to the US dollar, which previously exported inflation to the US. As a result of the collapse in US demand, they’re devaluing their currency against the US dollar in attempts to make their goods cheaper here to stimulate demand. To their dismay, it ain’t working.
The reason why consumer demand is collapsing is that the US consumer is tapped out. No complicated theories needed. 70% of US GDP depends on consumer demand. Well, no money in consumers’ pockets, no demand. This autumn, banks taught the US consumer that there is a very real difference between cash and credit, and the US consumer has none of the former and depended on the latter. Credit is being pulled out of the consumer’s reach with increasing speed and thoroughness, which means that the consumer is going to have to pay down his debts before he can start spending again. Given how fast debt was increased from 2000 to now, that will take years of enforced saving to accomplish.
That’s why cars, houses, crap from China, you name it — nothing is selling. The credit-financed consumption party is over.
Now, if the Fed allows inflation to get out of control (and it won’t until and unless the banks start lending all the cash on their balance sheets), the Chinese might well say “Hey... you’re trying to inflate your way out of paying your debt to us...”
And that would be a valid complaint. What they would do first is quit buying NEW debt before they go dumping the debt they currently hold. This would cause interest rates to go up on Treasury debt before we’d see an explosion in inflation, because the Treasury still has to find someone to sell that paper to. Absent the ChiCom’s buying program with their surplus of dollars, the interest rate will have to go up to attract money out of other asset classes to buy US debt. If there is inflation at this point or seen into the foreseeable future, the interest rate at auction will go up to some rate above what the rate of expected inflation is, and other lines of credit will have to go up based on spreads over benchmark Treasury rates; the increase in interest rates would choke off more debt being issued, and would result in more money being put into Treasuries instead of other forms of debt (a reversal of what Bernanke is trying today by gutting Treasury yields). The economy slows down more, and inflation is checked.
So let’s take this one more step: the ChiCom’s not only stop buying new debt, they start dumping existing debt. Now interest rates go up like a homesick angel - because the face value of existing Treasuries starts to go down as a result of the market being flooded with Treasury paper (eg, look at auto company bonds, paying over 40%). The US economy now really tanks - as in, we’re WISHING we had a Dust Bowl, because it would look better than what we have as a result of 20%+ Treasury yields.
OK, so what happens to China then? They collapse. Completely. Their economy is based on exporting crap to us, and if the interest rates go up like a rocket, the US economy just packs it in and we’re in a situation where we simply cannot afford anything made in China (or anywhere else, for that matter). The Chinese are already seeing domestic civil unrest and riots due to how the economic slowdown has hit them already. Let’s say that not only are toy exports to the US cut by 50% in 2008, but by 2009 (or 2010), there are almost no toy (or any other) export to the US. The US trade imbalance with China levels out because we’re unable to buy anything from them. What happens to China?
They’re toast, along with us.
So if they’re thinking this all the way through, they’re going to think for a sec before they dump their T’s at the market.
Another thing I think that people are not factoring in on China is how much of their domestic economy was based on the run-up to the Olympics. To us, this sounds completely silly. In their economy, the amount of building, primping, etc for the Olympics was absurd and a significant component of their economic growth. As soon as the Olympics were over, their economy started downhill - fast.
The only way I see inflation getting out of hand is that if the banks decide that they’re going to forego the interest being paid on reserves by the Fed and actually start lending money. Right now, banks are not lending - all the money that the Fed is “printing” is ending up on bank balance sheets - and there it is staying. So while it looks like the Fed is running the presses non-stop, the money hasn’t actually made it into the economy as of yet, where it could chase goods and services.
If the banks were to start to lend as a whole too quickly, Bernanke can do a couple of things to pull out huge wads of liquidity from the banking system literally overnight:
1. Call back the debt swaps he’s made.
2. Raise reserve requirements.
Right there, without even touching interest rates, huge swathes of liquidity come out of the banking system.
Guys like Janszen might be right. But for him to be right, the Chinese have to have to be ready to commit economic suicide. I don’t think that they’re quite ready to do that.
Very nice analysis.
RE post 26, great analysis.
We will revert to a world without such a reserve, or we will not.
I also believe that you are likely correct that no other currency, whether an existing one or some newly constructed one, is likely to be able to step into the role of such a reserve currency.
So either the dollar stands, or we revert.
And further I pretty much agree with your analysis of the situation with China. If we cannot put the current house of financial cards back together, their economy is toast.
We seem to disagree only on which outcome is more likely, the continuation or collapse of the current system.
You seem to be presuming that the political and financial leaders of the world have some ability to choose whether this happens, and since they won't want to see their economies collapse, they will choose to keep the present financial system running.
Eric Janszen is figuring that we, including our leaders, have run out of room to keep the present financial system running.
Actually, if my memory is correct, Eric made a similar call for a collapse after the dot-com bubble burst. He did not anticipate the mortgage debg and housing bubble.
I am rather confident that sooner or later, the current financial system will collapse, and that as we all seem to agree, that will be ugly. I think I know what will happen, but I cannot be certain of when it will happen. My current estimate is that most likely the collapse will be in the next year or two, on the demise of an aborted Dollar/Treasury bubble. But I am open to the possibility that I am off by one bubble. I seriously doubt that I am off by more than one bubble; which is to say I am confident that the worlds current financial system (dollar as the reserve currency, Americans borrow and spend, upcoming nations lend and sell) will collapse within the next ten years.
By this time next year, I'll wager that you agree on this.
How much reserve currency is needed? The Chinese took a ton of dollars in exchange for their goods so they could build their manufacturing, not because they needed to build their reserves. There was no reason to dump those dollars in the past but their buying spree around the world shows they want to exchange as much of those assets for more diverse ones, particularly resources.
If I had read those words last summer, I would have thought you were absolutely right. But after the last quarter of 2008, I am not so sure that Treasury will act rationally. Or maybe it is acting "rationally" in a cynical sense, but not in the best interests of most people in this country.
Assuming that whoever has profited from the mortgage scams and bailouts currently have their money in US dollars, keeping the dollar's value from crashing would benefit them. But if a major part of the profits already have been moved to investments not directly linked to the USD, that would not be good IMO.
I don't know, you may be right that, in spite of everything, the governments will realize that world commerce depends on a standard currency, assuming that they want commerce to continue. I don't know if rats are jumping off a sinking ship, but since the 700B bailout did not require disclosure, it's hard for us peons to know. Judging by what I have seen, I am not counting on the powers to do what is best for you and me.