Post Mortem for the World’s “Reserve Currency”

GREETINGS,

  ” The strong-hold of the American government is falling to pieces. She has lost her prestige among the nations of the earth. One of the greatest powers of America was her dollar. The loss of such power will bring any nation to weakness, for this is the media of exchange between nations. The English pound and the American dollar have been the power and beckoning light of these two great powers. But when the world went off the gold and silver standard, the financial doom of England and America was sealed.

 The pound has lost 50 percent of its value. America’s dollar has lost everything now as power backing for her currency, which was backed by gold for every $5 note and up. All of her currency was backed by silver, from a $1 note up.

 But today, the currency of America is not backed by any sound value – silver or gold. The note today is something that the government declares they will give you the value in return, but does not name what the value is. But they definitely are not backing their currency with silver or gold.

 This is the number – one fall, and it is very clear that the loss of the power of the American dollar means the loss of the financial power of America. What will happen since there is no sound backing for her notes we do not know.”–pg.87(THE FALL OF AMERICA)

Post Mortem for the World’s “Reserve Currency” 

By Mike Whitney

Paul Volcker is worried about the future of the dollar and for good reason. The Fed has initiated a program (Quantitative Easing) that presages an end to Bretton Woods 2 and replaces it with different system altogether. Naturally, that’s made trading partners pretty nervous. Despite the unfairness of the present system–where export-dependent countries recycle capital to US markets to sustain demand—most nations would rather stick with the “devil they know”, then venture into the unknown.  But US allies weren’t consulted on the matter.  The Fed unilaterally decided that the only way to fight deflation and high unemployment in the US, was by weakening the dollar and making US exports more competitive. Hence–QE2. 

But that means that the US will be battling for the same export market as everyone else, which will inevitably shrink global demand for goods and services.  This is a major change in the Fed’s policy and there’s a good chance it will backfire. Here’s the deal: If US markets no longer provide sufficient demand for foreign exports, then there will be less incentive to trade in dollars. Thus, QE poses a real threat to the dollar’s position as the world’s reserve currency.   

 Here’s what Volcker said:  “The growing sense around much of the world  is that we have lost both relative economic strength and more important, we have lost a coherent successful governing model to be emulated by the rest of the world. Instead, we’re faced with broken financial markets, underperformance of our economy and a fractious political climate…..The  question is whether the exceptional role of the dollar can be maintained.”  (Bloomberg)
This is a good summary of the problems facing the dollar. And, notice that Volcker did not invoke the doomsday scenario that one hears so often on the Internet,  that China–which has more than $1 trillion in US Treasuries and dollar-backed assets–will one day pull the plug on the USA and send the dollar plunging.  While that’s technically true, it’s not going to happen. China has no intention of crashing the dollar and thrusting its own economy into a long-term slump.  In fact, China has been adding to its cache of USTs because it wants to keep its own currency weak and maintain its hefty share of the global export market.  Besides, China didn’t become the second biggest economy in the world by carrying out counterproductive vendettas against its rivals.  It’s going to stick with the strategy that got it to where it is today.  
Still, as Volcker points out, there are real threats to the dollar, and they’re getting more serious all the time. For example, if the deficits continue to balloon as they have recently ($1.3 trillion in 2010) or if Fed chairman Ben Bernanke follows QE2 with QE3, QE4, QE5 ad infinitum, then foreign investors and central banks will begin to lose confidence in the US’s ability to manage its finances and they will begin to ditch the dollar. That will increase the cost of funding government operations by many orders of magnitude. In fact, it looked like something like that was happening just last week when President  Obama announced his approval for extending the Bush tax cuts. The markets figured that extending the cuts would swell the deficits which would force the Treasury to issue more debt. That triggered a flight out of USTs that sent yields up sharply.  The bond market suffered its biggest 2-day selloff since 2009. The incident provided a snapshot of what’s in store when the economy begins to recover and the government has to pay higher rates to service the debt.
In any event, the one-two punch of bigger deficits and QE cannot help but push the dollar lower, but that does not necessarily imply that the dollar will lose its top-spot as reserve currency. It’s more complicated than that.
Here’s how  economist Menzie Chinn summed it up when he was asked how it would effect the US economy if the dollar lost its position as the world’s reserve currency:
   “If the dollar does indeed lose its role as leading international currency, the cost to the United States would probably extend beyond the simple loss of seigniorage narrowly defined. We would lose the privilege of playing banker to the world, accepting short-term deposits at low interest rates in return for long-term investments at high average rates of return. When combined with other political developments, it might even spell the end of economic and political hegemony.”
Maintaining reserve status is the great imperative, because reserve status is the cornerstone upon which the empire rests. Lose that, and the whole superpower phenom begins to teeter. So, quirky, untested policies, like QE, are not initiated without a great deal of thought. (and apprehension) The Fed tries to anticipate what could go wrong and work out an exit strategy. Kevin Warsh, who is a member of the Board of Governors at the Fed, gave a good rundown of the potential problems with QE in an article in the Wall Street Journal. Here’s an excerpt:
  “The Fed’s increased presence in the market for long-term Treasury securities also poses nontrivial risks. The Treasury market is special. It plays a unique role in the global financial system. It is a corollary to the dollar’s role as the world’s reserve currency. The prices assigned to Treasury securities–the risk-free rate–are the foundation from which the price of virtually every asset in the world is calculated. As the Fed’s balance sheet expands, it becomes more of a price maker than a price taker in the Treasury market. And if market participants come to doubt these prices–or their reliance on these prices proves fleeting–risk premiums across asset classes and geographies could move unexpectedly. The shock that hit the financial markets in 2008 upon the imminent failures of Fannie Mae and Freddie Mac gives some indication of the harm that can be done when assets perceived to be relatively riskless turn out not to be.” (“The New Malaise”, Kevin Warsh, Wall Street Journal)
This is an astonishing admission for an acting member of the Fed.   Warsh is basically conceding that the Fed is price-fixing on a global scale (“more of a price maker than a price taker”) and he worries that this could undermine confidence in the bond market.  The danger, as he sees it, is that investors will see through the ruse of government guarantees (like those for Fannie and Freddie) and exit the asset class altogether sinking the dollar on their way out. This is the grimmest scenario I’ve seen yet, but it seems much more plausible than the “China will dump its Treasuries all at once” theory.
The administration’s support for Bernanke’s “weak dollar” policy  is evident in the way that Obama keeps reiterating his promise to double exports in 5 years. This simply can’t be done without ripping the dollar to shreds, which appears to be Obama’s intention. QE will lower the dollar’s value against a basket of currencies which will make US exports cheaper than the competition. Bernanke sees it as a way to narrow the output gap and lower unemployment by cranking up the printing presses. 
Foreign trading partners see it as beggar-thy-neighbor monetary policy at its worst, and they are deeply resentful. They’d rather see Congress do what it’s done in the past, and push through a second round of fiscal stimulus to boost  demand. They don’t care about how big the US deficits are as long as they are used for a good purpose. And pulling the world out of a global slump is a good purpose. But that’s not going to happen because the new GOP majority wants to implement their madcap “austerity” scheme which will bankrupt the states and dismantle popular social programs. They’re as committed to  “starve the beast” as ever, and they’re convinced it’s a winning strategy for retaking the White House in 2012.  But belt-tightening reduces demand which makes American markets less attractive for foreign products. If the US economy continues to  underperform, there will be less reason for foreign investors and central banks to stockpile dollars. The Fed’s QE, Obama’s export strategy, and the GOP’s plan for debt consolidation are creating ideal conditions for an unexpected plunge in the dollar.
But there are other problems facing the dollar besides falling value and droopy demand. As Volcker says, “We have lost a coherent successful governing model to be emulated by the rest of the world. Instead, we’re faced with broken financial markets, underperformance of our economy and a fractious political climate.”…..MORE HERE

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