The End of Dollar Supremacy?

Mises.org ^ | October 20, 2003 | Antony P. Mueller

[sourcery]

Given the current account deficit in the United States of more than five per cent and a negative net foreign investment position of over twenty per cent of its gross domestic product, it is the relative stability of the US dollar that needs explanation and not the fact that the effective exchange rate of the dollar has declined by twenty per cent since late 2002. It is even more remarkable that U.S. interest rates did not have to rise as might have been expected in order to attract foreign investment as a compensation for the deficit in the current account.

Balance of payments numbers such as those the United States currently has would have broken many other currencies and would have triggered severe financial crises in other countries much earlier. But the United States is different. It holds a privileged position within the international monetary system and its path to ruin may be longer and smoother than that for other nations. Nevertheless, even for the U.S. there is a limit and the country seems to be getting closer to it every day.

The relative strength of the US dollar despite the deteriorating external position results from the role of the dollar as the world's global reserve currency and because the pillars on which the dollar's supremacy rests do still seem intact. Furthermore, there is not yet a ready substitute for the dollar in sight which could replace it as a functioning global currency.

Compared to its potential rivals such as the euro or the yen, the US dollar has a historical and a quantitative advantage. For more than half a century, the world-wide use of the US dollar has been common practice. The dollar is the unrivalled global currency, a currency whose position as an international means of exchange rests on a prolonged experience. The dollar's origin as to its source of production is the visible power of the United States in terms of its national unity and its global military presence. Additionally, the dollar's predominance rests on the strength of the U.S. economy as there is no other economy of size which could match it in terms of productivity and innovation. 

All these pillars have strengthened since the early 1990s. The use of the dollar has become more widespread on a global scale with the integration of the former Communist countries into the world economy; the position of the United States as the principal global political and military player has strengthened with the fall of the Soviet Union; and, particularly since the mid 1990s, the American economy has experienced a period of outstanding dynamism and resiliency.

So why the jitters about the imminent decline and fall of the US dollar that have emerged? Isn't there reason to believe that the dollar's supremacy will remain undisputed in the future as well?

Unfortunately, the outlook is more dramatic than the question may suggest at first glance. The dramatic statement says that?at least for a while?the dollar will not be replaced by another global means of exchange but that the dollar may lose its supreme role nevertheless. A fall in the dollar from its pedestal with no substitute to replace it would be the very disturbing outlook suggested by an interpretation of the current trends. The disastrous consequences of the demise of the dollar as the global currency with no other means of exchange to replace it refers to the outlook that we may enter a period of currency chaos and a global economic contraction.

Losing trust does not mean that there must be a ready substitute. On the contrary: when distrust will emerge towards the US dollar this would affect the attitude towards all paper currencies. In the final stages of the currency crisis, the dollar will most likely devalue not so much against the euro and the yen, but all of these currencies and most of the rest will devalue drastically against gold.

There is neither a theoretical nor an empirical reason to believe that the dollar should be different from the other fiat currencies that have emerged and disappeared in the past. Even more so, given the unique position of the dollar in the current monetary system, the temptation to abuse this privilege has been greater for the United States than that which inflicted other nations and led to their decline. 

From early on, the United States has taken advantage from the privileged position of the dollar in the modern monetary system, but it has been essentially only since the early 1980s when the enjoyment of a privilege began to turn into an abuse; and it is only in the past couple of years or so when the abuse has turned into an almost complete lack of consideration. In due course, confidence of private investors has begun to erode.

In the past couple of years there has been a massive fall of foreign direct investment flowing into the United States and in 2002 the flow became negative (see table 1). In 2001 the basic balance turned negative and reached 218 billion US dollar in 2002. This signifies that there is less capital inflow to compensate for the expanding current account deficit.

Table 1

United States. Current account and composition of capital account 2000?2002 (a)

	2000	2001	2002
	Current Account	-410	-393	-503
Net long-term capital hereof:	422	335	285
Direct Investment		129	3	-93
Equities	90	15	35
Bonds	203	317	343
Basic Balance (b)	12	-58	-218

(a) in billions of US dollars
(b) Current account plus net long-term capital
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table II.4

It has been mainly due to the buying of bonds by foreign central banks that a dollar crash has been averted so far. The massive buying of U.S. bonds by central banks in 2001 and 2002 has led to an increase in global US dollar reserves which surged by 219.8 billion in 2002 reaching a total of 1,751.4 by the end of that year (see table 2).

Table 2

Annual changes in official foreign exchange reserves 2000-2002 (a)

	2000	2001	2002	Total end-2002
Dollar reserves	115.5	82.9	219.8	1,751.4
Other currencies	75.2	58.1	48.6	643.8
Total reserves	190.7	141.0	268.4	2,395.2

(a) in billions US dollars at constant exchange rates
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table V.1

The major buyers of U.S. debt among the central banks are now located in Asia, and here particularly in China, Hong Kong and Taiwan (see table 3). This trend?that central banks substitute private investors and thus stabilize the dollar?will hardly be sustainable.

Table 3

Annual changes in official exchange reserves. Selected areas (a)

	2000	2001	2002	Total end-2002
Euro Area	-9.4	-10.8	8.0	215.8
Japan	69.5	40.5	63.7	451.5
Asia (b)	52.5	76.0	173.3	943.8

(a) in billions US dollars at current exchange rates
(b) mainly China, Hong Kong SAR, and Taiwan
Source: Bank for International Settlements, 73rd Annual Report, Basel 2003, table V.1

A situation like this which has emerged over the past few years implies an increasing financial vulnerability of the United States. If the buying spree by foreign central banks should stop or even reverse, the impact would affect the dollar exchange rate, the treasury market and the domestic price level with the consequences of a sinking dollar, a sharp rise of domestic interest rates and an increased inflation rate. It is highly unlikely that the American economy would prove resilient enough to withstand such a triple blow.

The coming of a dollar crisis would expose the internal fragilities of the U.S. economy which currently are largely hidden. Along with the end of the favors for consumers to indulge in spending and for private and public debtors to have their investment and budget deficits financed by foreigners, a decline of the dollar would expose the lack of a balanced industrial structure in the United States.  More than twenty years of persistently high trade deficits have led to an industrial structure which has made the United States highly dependent on foreign imports with a lack of domestic suppliers that could readily substitute dearer imports.

What would happen if the dollar should surpass the threshold and a crisis of confidence emerges? The consequences would not be confined to the United States itself. The dollar crisis would affect the rest of the world and it would put the current international monetary system at stake with the potential of bringing it down. While the pillars on which the dollar stands may still seem to be intact today?the statue itself may come down. But when the dollar should fall, the pillars on which it has stood, will crumble too.

Given the trend that the U.S. foreign debt position will continue to deteriorate, a severe dollar crisis seems almost inevitable. But this is only half of the story. The dramatic part of the enfolding scenario is that there is no ready substitute for the dollar as a global currency and that the dollar crisis will put the overall economic and political position of the United States at risk. With the loss of the privileged position of the dollar the economy would weaken and this in turn would undermine the political role that the Unted States plays presently as the world's hegemon.

International finance is closely intertwined with international politics. While a predominant role in international finance does not come without the basis provided by politics, it is sound finance on which the continuation of the dominant global role will depend later on. Both of these, however, have a more profound basis: it is basically the ethical attitude to the matters of money and finance, the deeply rooted sense for prudence and rectitude, which is required to be maintained in order to keep the privileged position.

Near the end of the Hapsburg Empire, before the outbreak of World War I, Eugen von Böhm-Bawerk wrote in his essay "Our passive trade balance"[i] that all those theories brought forth to explain the persistently negative trade balance of the Austro-Hungarian Empire?such as a surge in industrial strength and its attractiveness for foreign investment?do not stand a more profound analysis. These argument would imply that the "passivity" would be transitory. The persistency of the trade deficits requires that the situation be analyzed beginning with the capital balance, and this way, Böhm-Bawerk pointed out, the negative trade balance had its roots in a lack of domestic savings, the unproductive use of resources and "wasteful consumption" (pp. 509).

A "change of mind" had occurred, said Böhm-Bawerk, and the accumulation of massive deficits reflected a "lack of morality" (p. 511): "We slithered from surpluses into a phase of easy-hearted and willing expenditures, and we continued to slither even after the surpluses were long gone."[ii]

---

[i]Eugen von Böhm-Bawerk: Unsere passive Handelsbilanz (1914), in: F. X. Weiss (ed.):  Gesammelte Werke von Böhm-Bawerk, Vienna and Leipzig, 1926, pp. 449?515.

[ii]Translated by the author of this article.

-----------

Antony Mueller is a professor of economics at the Universidade Caxias do Sul in Brazil and a member of the Institut für Wirtschaftswissenschaft of the University of Erlangen-Nuremberg in Germany. He is also an adjunct Scholar of the Mises Institute. Antonypmueller@aol.com

[AdamSelene235]

Medical care, housing, and education are special cases.

They are also fundamental to decent existence.

[sourcery]

Whose money do ou want long term?

Whichever one will best keep its value. And the USD isn't the one that wins that contest over any time period since the US went off the gold standard. Swiss francs have done exceptionally well since that time. The CHF was taken off the gold standard only recently.

If a deflationary debt collapse is in the US's future (as I believe,) then the USD would actually be a good investment. Otherwise, gold would be superior.

[Tauzero]

Yes, but so what?

The rising price of them is primarily an artifact of government regulatory policy and subsidy, which on the one hand increase costs and on the other hand increase demand over what they would be under a free market. It's not primarily an inflationary phenomenon.

[AdamSelene235]

How do you propose to measure inflation?

One approach would be simply to measure the cost of essential items.

Another, and more fundamental, would be to measure the money supply.

[AdamSelene235]

The rising price of them is primarily an artifact of government regulatory policy and subsidy, which on the one hand increase costs and on the other hand increase demand over what they would be under a free market. It's not primarily an inflationary phenomenon.

Of the three items named, I would agree with you with the exception of housing prices.

[AdamSelene235]

The rising price of them is primarily an artifact of government regulatory policy and subsidy, which on the one hand increase costs and on the other hand increase demand over what they would be under a free market.

This is the case for nearly every good or service I can think of.

[Tauzero]

And how do you define an essential item?

"Another, and more fundamental, would be to measure the money supply."

Modify that with velocity and you've got a deal. :)

[Tauzero]

"I would agree with you with the exception of housing prices."

So they would've risen dramatically w/o the GSE's?

[Tauzero]

" This is the case for nearly every good or service I can think of."

Question of degree.

[kanawa]

"It is interesting to note that thc U.S. five-cent piece, commonly called a 'nickel,' has never contained more than 25 per cent nickel."

Now this is a Nickel...

The Big Nickel is the largest coin in the world. It was constructed in 1964. It is an identical, enlarged replica of the 1951 Canadian nickel. Heads is King George VI, Canada’s monarch in 1951. Tails is a stylized nickel refinery with one large stack. The Big Nickel weighs close to 13,000 kilograms (approximately 13 tons). It stands nine metres (30 feet) high. It is 61 centimetres (24 inches) thick. It is about 64,607,747 times the size of a Canadian nickel.

[kanawa]

Aaarrrggghhh...http://www.boldts.net/album/BigNickel.shtml

[AdamSelene235]

Yeah, I figured we didn't have the discipline to remain on even a nickel standard.

[AdamSelene235]

So they would've risen dramatically w/o the GSE's?

I doubt it. But could the GSEs acheive their results without easy money? Also dubious.

Modify that with velocity and you've got a deal. :)

Velocity assumes money isn't money unless its being used as money. I don't care much for this asssumption as the system we are dealing with is multivariable, highly nonlinear, and contains a multiplicity of time constants. I suppose velocity may be useful to provide a snapshot of your current predicament, but I doubt velocity and supply alone will give you any predictive ability.

[zechariah]

I for one am outraged by the falling prices of ... soy beans,

I saw a chart of soybeans today. That market has been consistently gapping open. Very impressive. Wish I were in it.

[z]

[Bob J]

Click Here for the RadioFR website!

Tonight on Radio FreeRepublic

Unspun with AnnaZ
October 23rd, 2003 -- 10pmE/7pmP

"At least when right-wingers rant, there's a point!"

Click HERE to listen LIVE while you FReep!

Would you like to receive a note when RadioFR is on the air? Send an email to radiofreerepublic-subscribe@radioactive.kicks-ass.net!

Click HERE to chat in the RadioFR chat room!

[Starwind]

Foreign Lenders Bolting?
http://www.marketwise.com/MW_Newsletters/MWBlackBox.html
by Rick Ackerman


How much longer will foreigners continue to support America?s $1.5 billion-a-day borrowing habit? Figures released by the Treasury Department yesterday indicate they may already have turned off the credit spigot. Net capital inflows into the U.S. plummeted from $50 billion in August to $4.2 billion in September, implying that foreign investors have recently begun to direct their surplus funds elsewhere. Sales of Treasury bonds accounted for nearly $20 billion of the slippage. While foreigners bought a net $25.1 billion of Treasurys in August, their purchases in September netted out to just $5.6 billion. The reversal was even more decisive in the mortgage markets, where they sold a net $3.2 billion of Fannie Mae and Freddie Mac paper after buying $8.9 billion of it the previous month.



Because the selling has been mostly from private accounts and hedge funds rather than by central banks, it is unlikely the trend can be reversed by mere political jawboning. It is global market forces at work, after all, and the selling could intensify beyond remedy if perceptions of the dollar should take a serious turn for the worse. With the current-account deficit expected to reach $550 billion this year, foreign credit has become essential to America?s day-to-day business. The trade deficit has burgeon steadily since the early 1990s, but the offset of increased foreign lending has prevented it from becoming a crucial problem.



Recovery in Jeopardy



Until now, that is; for, our dependency on foreign money to bridge the gap between what Americans earn and what they spend has grown to the point where even a relatively small shift out of dollar assets by global investors could jolt financial markets badly enough to derail the U.S. economy. Meanwhile, significant buying of U.S. assets by the Japanese has long been an important prop for the dollar. Most recently, the Japanese bought a net $20 billion worth of our bonds and equities in September, impelled by the need to boost exports with an undervalued yen. They are acting in self-interest, of course, but their motive could take an ugly turn toward self-preservation if the rest of the world should start dumping dollars. That is one reason why I will continue to recommend gold assets, and to regard each and every dip in the price of mining shares as an opportunity.

[Starwind]

US Treasuries subdued, foreign cenbanks stay away
Wednesday November 26, 11:20 am ET

NEW YORK, Nov 26 (Reuters) - Treasury prices drifted lower on Wednesday after an auction of new U.S. government debt disappointed and the breakdown of bidding suggested foreign central banks were not as big buyers as in the past.

The $26 billion of two-year notes went at a yield of 1.939 percent, having traded around 1.93 percent before the sale closed. The auction drew bids for only 1.75 times the amount on offer, well below the 2.12 achieved at the last sale.

Indirect bidders, which mainly comprise foreign central banks, picked up 32 percent of the issue, much less than the 44 percent they took in last sale in October. The appetite of offshore central banks has become a big issue for the market since they have been major buyers of Treasuries this year and currently hold over $800 billion worth.

The current two-year note (US2YT=RR) slid 3/32 in price, nudging its yield up to 1.89 percent from 1.84 percent late on Wednesday. Benchmark 10-year notes (US10YT=RR) fell 6/32, taking its yield to 4.21 percent from 4.18 percent.

[imawit]

Very appropriate post. Just starting to relax after the morning stock workout. Whew, puff, puff, puff.

If this keeps up, I can retire. RIGHT NOW !

[Starwind]

=DJ World Forex: Dollar Slides, Ignores Strong US Data Blitz

.
By Jamie McGeever and Tom Barkley
OF DOW JONES NEWSWIRES


NEW YORK (Dow Jones)--In a startlingly counterintuitive reaction to another round of excellent U.S. economic data, the dollar plummeted across the board Wednesday, with its sharp decline accelerated by stop-loss sell orders triggered in thin trade.

Immediately following the release of soaring October durable goods orders early in the day, the dollar tried to move higher. But the euro's support at $1.18 held firm and the market quickly turned around, with sentiment toward the dollar souring rapidly.

Strong consumer confidence and Chicago area manufacturing data released later in the morning failed to spark a recovery and the dollar was trading near session lows Wednesday afternoon, as activity wound down ahead of the Thanksgiving Holiday in the U.S.

The heaviest losses were against the European major currencies, with the dollar losing 1% against the euro and nearly 2% against the Swiss franc.

To be sure, markets were jittery about potential terrorist threats heading into the Thanksgiving holiday, which many in the U.S. extend into a four-day weekend. A scare on the New York subway, that turned out to be related to six transit workers overcome by fumes while working on a Manhattan train line fed into the dollar weakness, underscoring that fact. But there's a more fundamental tale behind the currency's woes also.

"A massive dose of strong data seems to already be discounted by the market," said Lara Rhame, senior economist at Brown Brothers Harriman in New York. "This reinforces our notion that market participants no longer measure the U.S. economy on a scale of 1 to 10, but 10 to 20. In this environment, it becomes hard to construct an upside surprise for data."

The data were indeed positive. Durable goods orders in October were up 3.3%, consumer confidence in November as measured by the University of Michigan rose to its highest level since May 2002, the Purchasing Management Association of Chicago business activity index hit a nine-year high, and the number of workers filing first-time applications for unemployment benefits dropped to a 34-month low last week, indicating steady improvement ion the jobs market.

But there was no stopping the dollar's slide in holiday-thinned trade. Late Wednesday afternoon, the euro was at $1.1930, well above $1.1783 late Tuesday in New York. The single currency also broke above Y130.00 resistance to end at Y130.10, up from Y128.98.

Against the Swiss franc, the dollar fell to CHF1.2940 from CHF1.3190 while sterling climbed to $1.7115 from $1.6982, hitting a new five-year high in the process. Against the yen, the dollar dropped to Y109.10 from Y109.43 late Tuesday.

Spurred on by the dollar's slide, however, the price of gold rallied Wednesday to briefly nudge $400 a troy ounce before easing back to $396.63/oz, still up $5.38 from late New York Tuesday.

-By Jamie McGeever, Dow Jones Newswires; 201-938-2096; jamie.mcgeever@dowjones.com


(END) Dow Jones Newswires

11-26-03 1516ET- - 03 16 PM EST 11-26-03