The 'Triffin Dilemma'
In the 1960's, American economist Robert Triffin identified what later came to be known as the 'Triffin dilemma'. The Bretton Woods system, so Triffin, that had made the US dollar the world's 'reserve currency' necessitated that the US run a perennial current account deficit in order to satisfy the demand for dollars as a reserve asset (we can assume that the same idea holds for its 'gold-free' successor).
At the time Triffin formulated this idea, exchange rates were still fixed against each other and ultimately tied to gold, which in turn could be bought (only by central banks) at a fixed exchange ratio to the US dollar ($35/oz.). Triffin probably thought that a problem would arise if too many foreign central banks were to demand gold in exchange for their dollars at some point – the gold exchange standard would then come under strain. Why did he think so? By 1959, the amount of dollars in circulation began to exceed the amount of gold held in reserve against them. A first sign of the brewing problem was provided by the fact that by 1960 gold traded at around $40/oz. in London – five dollars above the official $35 exchange rate at which central banks could still demand gold from the US treasury.
A friend recently sent us a link to this article at Reuters, where the so-called Triffin dilemma is discussed in the context of the vast global imbalances that have accumulated over recent decades. In particular it is held that the accumulation of US dollars by mercantilist export oriented nations such as China once again creates a kind of 'mutually assured destruction' scenario between these nations and the US, not unlike what the UK experienced when the 'Sterling zone' came to an end. The author discusses the hitherto unresolved question whether the US are to be blamed for the situation, or if it is the fault of the trade surplus nation du jour (the alleged culprits have changed over time – in the 1960's, France and Germany were the big surplus nations, later it was Japan, now it is China – and they all became the targets of US complaints). The Bernankean 'savings glut' theory is mentioned as well. In brief, the 'savings glut' theory holds that what was really responsible for the US housing bubble was not the Federal Reserve, but unconscionable savers in Asia, who by dint of saving too much provided the fuel for the bubble. This is extremely convenient, as it lets the Fed off the hook. It is therefore no wonder that Bernanke is enamored of the idea. In addition, it goes well with the Keynesian canard that 'savings are bad'.
Now step back for a moment and reconsider all of the above. There's a 'dilemma'? Why should that be so?
As it were, we have a perennial trade deficit with our grocer (we supply him with euro reserves, which are currently a little less fashionable). Somehow that has not yet become a problem, neither for us nor for the grocer. No bubbles have developed, and we're not likely to be miffed if the grocer lowers his prices and certainly won't try to talk him into raising them again. We definitely won't accuse him of 'unfair dumping' that is detrimental to competing grocers.
Wait a minute, say the dilemma people, you and your grocer are not relevant to this discussion. You're not entire nations after all.
And this is where we come to the crux of the whole issue. Modern-day macro-economists like to lump things together into aggregates, so that they have something they can observe and 'measure' (one must be very careful with the term 'measurement' here, for both practical and theoretical reasons). Thus trade is deemed to occur 'between nations', which are envisaged as moving big lumps of goods and money back and forth between each other every month (as a rule, the statistics are gathered on a monthly basis).
However, this is simply not the proper way of looking at trade. Trade takes place between individuals and/or between companies, not between 'nations'. Let us say for example that an American citizen decides to buy a coffee machine from a Chinese merchant for $60. What happens here is that the American buyer values the Chinese coffee machine more than the $60 he gives up to obtain it (implicitly, since he could have used the $60 for other purposes, he also prefers the coffee machine over other alternatives). The Chinese company in turn values the $60 more than the coffee machine. In other words, both parties to this trade are profiting from it. This is a self-evident truth – there is absolutely no need to 'prove it': the fact that the trade has taken place proves the proposition that it is beneficial to all concerned ipso facto (assuming of course that it was voluntary and that no-one had a gun put to his head).
This doesn't change if instead of one buyer, a thousand buyers were to decide to enter into a similar trade, or if all Americans henceforth bought only these China-made coffee machines. The activity must be beneficial to both parties to the trade.
The conclusion from this must be that there can neither be any harm in a 'trade deficit' nor can there be any harm in a 'trade surplus'.
The True Nature of the Problem
However, is it not also true that we can for instance observe that e.g. China's artificial exchange rate and constant accumulation of foreign exchange reserves leads to high rates of monetary inflation in China?
[As an aside to this we should point out that it is not possible to assert that the yuan's exchange rate is 'too low'; for all we know, it may well be too high. This is something that can not be ascertained while it is not trading freely. All we can ascertain is that the pace of monetary inflation in China has exceeded monetary inflation in the US or a very long time. It seems more likely that the yuan is in fact overvalued rather than undervalued.]
Is it not also true that measures of 'global excess liquidity' seem to correlate closely with the amount of dollar reserves accumulated abroad and that this excess liquidity is indeed instrumental in furthering capital malinvestment and creating asset price bubbles and all the problems associated with them?
In short, even though we can assert by means of logical deductive ratiocination that all voluntary trade must be beneficial to the parties involved, there does nevertheless appear to be a problem.
However, policymakers and their advisors who plan and implement the world's 'managed trade' regime and are responsible for the financial and monetary architecture underlying it, misdiagnose the problem. It can therefore not be 'solved' by the interventionist measures they propose. As far as we can tell, there are mainly two ideas that are being considered.
One is to simply resort to protectionist measures, such as the introduction of punitive tariffs on Chinese goods (the 'Krugman and Shumer solution'). There is no need to give a detailed account here as to why trade protectionism is an unalloyed negative (we will discuss some of the objections to free trade in more detail in a future post). Given that our standard of living depends on the accumulation of capital and the quantity of goods produced, any interference that restricts production and hence lowers the pace of capital accumulation and the quantity of goods being produced will evidently also lower our standard of living. As Ludwig von Mises notes in Human Action:
“On the unhampered market there prevails an irresistible tendency to employ every factor of production for the best possible satisfaction of the most urgent needs of the consumers. If the government interferes with this process, it can only impair satisfaction; it can never improve it.
The correctness of this thesis has been proved in an excellent and irrefutable manner with regard to the historically most important class of government interference with production, the barriers to international trade. In this field the teachings of the classical economists, especially those of Ricardo, are final and settle the issue forever.
All that a tariff can achieve is to divert production from those locations in which the output per unit of input is higher to locations in which it is lower. It does not increase production; it curtails it.
People expatiate on alleged government encouragement of production. However, government does not have the power to encourage one branch of production except by curtailing other branches. It withdraws the factors of production from those branches in which the unhampered market would employ them and directs them into other branches. It little matters what kind of administrative procedures the government resorts to for the realization of this effect. It may subsidize openly or disguise the subsidy in enacting tariffs and thus forcing its subjects to defray the costs. What alone counts is the fact that people are forced to forego some satisfactions which they value more highly and are compensated only by satisfactions which they value less.”
(emphasis added)
Obviously then, protectionism can not be a viable solution.
The other idea is to replace the US dollar with a different 'reserve currency' that is not issued by a specific nation state. The proposals that have been made in connection with this by e.g. Chinese officials harken back to Keynes' idea of the 'Bancor' – a 'stateless' fiat currency issued by an international bureaucracy, such as the IMF. Chinese officials specifically mentioned the IMF's 'special drawing rights' (SDR's) as a potential replacement for the dollar.
However, it should be immediately obvious why such an idea can not work. China's exporters accept dollars in exchange because they value dollars for a variety of reasons. Even though the dollar is a fiat money depending on the US government's 'promise to pay', it is widely accepted and used in international trade. Its viability as a medium of exchange is not – or at least not yet – in doubt. A merchant accepting dollars in payment does so because he expects that he can exchange them at a later date for other goods and services or other currencies. This is a reasonable expectation: for instance, almost $4 trillion are traded globally every day on the foreign exchange markets alone.
If one were to be dropped off in the near empty landscape of the Eastern highland of Anatolia with $100 in one's pocket and made one's way to the nearest nomad village, it would be a very good bet that its inhabitants would be prepared to exchange food and shelter for one's dollars (in fact we can confirm this from personal experience). Obviously, getting them to accept SDR's would be rather more difficult. The dollar is readily accepted as a viable medium of exchange due to its reputation and the faith in it that has been built up over time in spite of its obvious flaws.
China's gripe with the dollar is mainly that its 'reserve currency status' confers what is held to be an unfair and unearned benefit on its issuer, the United States. It is however notable that their proposal of how to improve on this point and make the system more fair focuses on creating yet another type of fiat money.
This brings us back to why there is actually a problem with 'global imbalances'. As noted above, trade deficits can not be a negative per se. Think back though to the 'dilemma' Triffin diagnosed in the 1960's. He intuited correctly that the creation of US dollars beyond their actual specie backing would eventually bring the Bretton Woods system down.
This immediately shows that the problem can not be trade – rather, the problem is the inflation of the money supply. In a monetary system theoretically 'backed' by gold such as Bretton Woods, this is immediately apparent: it won't be possible to satisfy the claims on gold of all dollar holders if monetary inflation is so great that the gold held in reserve provides insufficient backing. If such a system is rigidly enforced, the outflow of gold reserves will force the money issuing authority to eventually curtail and reverse the money supply expansion to restore balance. In the concrete case, the US decided to rather default on the gold exchange clause than to adopt a restrictive monetary policy.
The fact that today the whole world is on a 'fiat money standard' where dollars are no longer backed by anything and can be created at will only alters the problem in the sense of making it even worse, as it allows imbalances to grow unchecked for a long time (contrary to a gold reserve, the supply of dollars can never run out after all). There is nothing untoward about Americans buying more goods from China than Chinese are buying from the US. What is problematic is that this has been enabled by a vast increase in the supply of money and credit. In other words, it is the fractionally reserved banking system and the associated creation of money from thin air that creates the worrisome imbalances.
Whenever money from thin air enters the economy, it makes consumption without preceding production possible – 'nothing' is exchanged for 'something'. Putting it differently, when money created ex nihilo is used to purchase goods, then there hasn't been any offsetting contribution to the pool of real funding by the buyer. This will lead to capital being consumed over time, and will only appear to 'work' as long as the economy is still able to create more net wealth than is in effect consumed.
China's policymakers are correct to be worried about the unfair advantage that accrues to the issuer of the 'reserve currency'. After all, it can hardly be denied that exchanging pieces of paper that can be produced at virtually no cost in unlimited quantity for real goods must be advantageous to the issuer of the paper. The limit to this is obviously given by the willingness of Chinese merchants to exchange their goods for dollars, i.e., they will only engage in such exchanges as long as their faith in the dollar's viability as a medium of exchange remains intact. China's officials are rightly worried that the value of the large pile of dollars their central bank as accumulated as reserve assets may one day be subjected to a sudden negative reassessment by the market.
In this sense, there is a motive for the Fed not to 'overdo' its monetary pumping, but how can it possibly know where the limits actually are? The fact of the matter is that it does not know – the money supply could be growing very fast for a long time without negative effects that are immediately obvious, but this could change suddenly and with little warning (in what is known as a 'non-linear event' or a 'black swan').
In turn, the inflow of dollars has led to vast growth of the PBoC's balance sheet. Much of this has 'leaked' into China's economy in the form of very high rates of domestic monetary inflation, although the PBoC is trying to quell this by continually increasing the reserve requirements of China's commercial banks (the mix of the central bank's liabilities tilts toward bank reserve accumulation when this is done. Bank reserves are not part of the money supply, as they remain sequestered at the central bank).
Nevertheless, this 'sterilization' has been less than perfect, as China's government has allowed the rate of domestic monetary inflation to proceed at double digit rates for many years. After the 2008 bust the government ordered the banks to greatly expand their lending, further egging on credit and money supply growth. This has had precisely the effects economic law dictates: an orgy of capital malinvestment has ensued.
Everybody knows about the many empty apartment blocs and office towers, even entire empty cities in China. A huge network of high-speed railways has been built at enormous cost, but very few people are actually traveling on these trains – gigantic, brand-spanking new train stations are standing empty all day long. Untold amounts of scarce capital have been wasted in what appears to be the functional equivalent of pyramid building.
We can conclude that yes, there is indeed a 'dilemma' – but it consists of the practice of central-bank backstopped fractional reserves banking, the use of unsound money and the unchecked growth in the supply of money and credit this is enabling. In an unhampered market economy using a market-chosen money no such dilemma would exist.
Central Banks Around the World Open the Spigots
This bring us to what the world's central banks have been up to lately. As we have noted in previous articles recently, a concerted move toward easing monetary policy further appears to be underway. The ECB has implemented its new 'long term refinancing facilities' to ensure funding of the stricken banks in the euro area, the BoE has embarked on a fresh round of 'quantitative easing', the SNB has decided to peg the Swiss Franc to the euro (actually, it is not really a 'peg', rather, the SNB has established an 'upper limit' to the CHF's exchange rate), and even the BoJ has stepped up its asset purchase programs. The Fed meanwhile, after having announced that 'ZIRP' will remain in place until at least 2013 and implementing 'Operation Twist' is already talking about starting yet another round of MBS monetization. In major emerging market nations, only the Reserve Bank of India and the PBoC are still in a tightening cycle, but even that seems to be close to reversing (the RBI for instance hinted that its most recent rate hike would likely be the last). In other emerging market nations central banks have already begun to ease, such as e.g. in Brazil, where the central bank is increasingly worried about the possibility that a domestic credit bubble may be on the verge of imploding. The monetary spigots are in other words wide open now.
What all these activities have in common is that they involve more creation of money from thin air. Hence it should be expected that some prices in the economy will begin to rise, with varying lags.
Below are a few chart detailing central bank balance sheets and reserve balances.
