A crisis postponed

So much has been written about the coming $ crisis, but the $ keeps holding on, moving within a 5% band up and down, but not outside that band.   Why doesn’t the crisis come?   

The main reason is that it is a huge global currency subject to so many influences, whether it be in demand by all nations across the globe to pay for oil, or in demand by say Argentina to sell to meat to China.  As the currency in which 86% of the globes transactions were denominated the actual intrinsic value of the $ was not that pertinent.  This value, so it is taught, should reflect the entire Balance of Payments of the nation.   And it usually does.   However, in the past a currency was allowed to go further and reflect not only the Trade Balance but the real attractiveness of the nation as a place to put one’s capital.   In the seventies Germany was remarkable with its economic strength forcing it to revalue many times, it was in such demand.   It had a surplus on its trade balance as well as on its capital account.   The main reason for either a devaluation or a revaluation was to steady the global flow of capital across the world leaving one nation facing a drain [e.g. the U.K. who imposed capital exchange controls to slow this down] and another the inflow of capital.

Today we have a remarkable and different situation where the $ is the currency of oil and the currency of global trade, not just the money of U.S. citizens.   On the home front the $ is the money of a country whose Balance of Payments should be devaluing hugely, but is not, because the persistent practice by nations receiving its currency is to re-invest these surpluses back into the States, so balancing the Balance of Payments through new capital investments.   But this is not because the U.S. is considered the prime place for nations to invest their capital as the U.S. is doing nothing whatsoever to rectify the Trade deficit except complain about the behavior of other surplus nations particularly China.   The reason is to keep the $ strong so the capital outflow can continue!  

So the expected $ crisis is averted time and time again!

The decline of the $

But there is a gentle and osmotic process underway, a lessening the role of the U.S. $ in the global reserves.   Alan Greenspan the ex-Federal Reserve Chairman has confirmed that both private investors and central banks are shifting away from the U.S. $ and toward the €.

On the date that the € was born, the switch of old now defunct European currencies to the € resulted in European reserves in the € constituting 16% of the global reserves according to the I.M.F.   Today, and mainly in the last year, that percentage has risen to 25%.   At that time the $ accounted for 76% of global reserves prior to 2005.  Today it is reported that they account for 65% of global reserves.   The switching has begun led by Russia, but with others beginning to follow.   

In line with Greenspan’s comments, nations have begun to diversify, but sensitive to the value of the $ on the global foreign exchanges, hoping they can retain its value but lessen the content in reserves, a delicate and easily upset objective.   This again serves to postpone the $ crisis, at the same time exacerbating it and ensuring it will be increasingly detrimental to the entire global monetary system.   The changes in the structure of global reserves will be slow it seems on the surface, but at some point in this transition the pressure will be too great and will precipitate a $ crisis of unseen proportions.

Protectionism & Capital Controls?

Greenspan put it this way from the U.S. perspective, “We'll get to the point at some point that willingness to finance it will slow, and if you can't finance it, it won't happen," Greenspan said of the broad trade measure.   Greenspan warned, however, that if the United States threw up barriers to isolate itself from the pressures of globalization, "the adjustment process could be a little bit more problematic." A little more problematic is a wonderful understatement.   Translated, this means Trade barriers rising against nations trading with the States and the possible use of Capital Controls to prevent capital from leaving the States.   Will this be confined to the reserves of those nations against whom barriers are erected?   If so, these nations are rapidly getting to the stage where they will be able to cope.   As the U.S. role as a global driver wanes, so will its ability to effect major trading partners wane with it.

But the immediate market effect, the effect on the global monetary system and the fear engendered in the stability of the global economy and its future will be far more dramatic. The isolation that the U.S. may impose on itself will allow the U.S. economy to boom tremendously as imports are replaced, but the inflation rate will roar alongside this change. Of course retaliation to such moves will find U.S. goods being replaced outside the States too, boosting the remaining major nations but leaving minor nations to take most of the blows.

The Capital Tsunami.

Such protectionism and capital flows [that were such a threat in the seventies] will be brought to a halt by restrictions, leaving some currencies to plummet in value whilst other rise leaving a situation that can rupture international trade.   Central Bankers in the States [Geithner] put this in words that at once interesting but obscure, when they say "And the forces that have produced this constellation of capital flows and market conditions will evolve in ways we cannot anticipate." A look at the seventies when such capital flows cased exchange rate havoc removes this mysterious veil and shows that such an evolution will prove traumatic to all across the world as they try to contain the Tsunami of capital looking for a place of value.   The size of this capital Tsunami was commented on by the U.S. Central Banker Geithner this way, “The dramatic increase in the foreign exchange reserves of central banks, particularly in emerging markets, is helping complicate how policy-makers adapt to the evolving global economy”.   We would suggest that they would fare no better than did the Central Bankers in Europe in the seventies and probably worse!   

With this wave growing rapidly [China's official reserves will likely hit $1 trillion this year, and some predict they will rise to $2 trillion by the end of 2010] past crises pale into insignificance against those that lie ahead.  A phlegmatic Geithner said, “large official flows of capital in one direction adds to the uncertainty over monetary policy, since they could mask underlying fundamental conditions that would otherwise affect asset prices, such as the sheer size of the U.S. fiscal and current account deficits.   Monetary policy-makers cannot ignore the international dimension. As economies become more open, external developments inevitably affect price and output dynamics.   The world may thus be more complex and, in some respects the conduct of monetary policy may be more challenging."  

Our comment on this is ‘Brace yourselves, lads!’

The full effect on the international financial system of vast foreign ownership of U.S. government debt was not fully understood, he said. 

Foreign central banks own more than a quarter of marketable Treasury debt.

[Next week] The importance of Marginal supply / demand in the Currency, Oil & Gold Markets and what the Chinese are doing and could do with their reserves.

© 2006 Julian D. W. Phillips
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