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How The Dollar Hegemony Fuels The US Twin Deficit And Produces An Ineffective Federal Reserve
Dee Woo, Beijing Royal School
Aug. 24, 2011,12:32
The recent US debt crisis and ensuing S&P downgrade has brought the whole world to a standstill. The scariest part is nobody knows how to react to a possible US default. The whole world has taken the US's solvency for granted for way too long. The booming global trade has been so heavily collateralized against the US deficit that we really don't know how it's going to function otherwise. World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. All the central banks need to accumulate dollars to sustain their undervalued currency and comparative advantage in trade. So what happens if the federal government goes bankrupted and the dollars become worthless? This is really a wake up call to all. The world needs to decouple its well being from the US deficit. We can't delay the inevitable for ever, or else next time it will be more than just a close call. We need to be prepared for a world without the dollar as the dominant reserve currency and global vehicle currency, and without the US consumption economy as the vital export growth engine. We need Euro to step up and take more responsibilities imbalance. Otherwise the world economy will continue functioning support the weight placed on them no more. The world has prospered on the debt-fueled credit binge in the US for decades. All good things come to an end. The dollar hegemony is a curse even to the US by inertia until the dollar and the US consumption economy can't over from the dollar, we need China to unleash a consumption economy to help solve the grievous global
Dee Woo Dee Woo is an economics teacher at the Beijing Royal School, a citizen economist, and a citizen diplomacy activist.
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The dollar hegemony has become the US's biggest disincentive to maintain its fiscal and monetary discipline. According to a report by the Division of Monetary Affairs from the federal reserve, since 1990 the US monetary expansion has been driven by the dominant external demand for the dollar. Hundred-dollar the Federal Reserve,which notes are the largest denomination now issued by make up 60 percent of the dollar value of all the U.S. currency outstanding. from abroad. On
The data on the use of $100 notes suggests that the net new demand for them is coming predominantly
average over the 1990s,the overseas stock of dollars has been growing about three times faster than the domestic stock. Empirically, the amount of currency outstanding typically grows in sync with,or even a little more slowly than, consumption in the United States. Indeed, this was the pattern until 1990. However, in the decade after 1990, in tune with the growing external demand for dollars,The US currency has grown about 3.5 percentage points more rapidly than consumption in nominal terms. People
would suggest these overseas dollars will probably be used to buy the US goods and service and therefore boost the US job markets. Nothing can be further from the truth. The majority of the overseas dollars are parked in treasuries and other dollar-denominated deficit(trade securities and assets by courtesy of the official foreign exchange holdings and Eurodollar market. They domestic demand in the US, which explains the self-enforcing mechanism of the US twin are fueling the debt-financed
deficit and fiscal deficit). central banks have assets of $4.4 trillion
According to Professor Robert A. Blecker's research, by the end of 2009,foreign
in the U.S ,which were 60% higher than the overall U.S. net debtor position of $2.7 trillion. (see figure 5) That is to say, excluding this colossal debt to foreign central banks, the U.S. was still a net creditor country to the tune of about $1.7 trillion in all of its other unofficial(i.e., non-central bank) international financial activities as of yearend 2009 (See figure 5). of U.S. assets after 2000 was not primarily driven by the increased confidence agents abroad, as contemplated in the models of "capital market
Hence the expanding foreign accumulation imperfections."
in the U.S. economy or U.S. assets by private-sector
On the contrary, it was mainly foreign central bank intervention that financed the growing U.S. twin deficits.
The dollar's dominance has done the US a huge disservice when it struggles to maintain its fiscal and monetary discipline and facilitated a vicious circle of twin deficits and weak dollar policy by the federal reserve. We all can see clearly the nature of self-destruction down this path.
Figure 5 U.S. net international investment position and foreign official assets In the US, yearend 1976 to 2009
-1,500 -2,000 -2,500 -3,000 -3,500 -4.000
U.S. net international investment position - - Foreign official assets in the United States
~ c ~
" ,V ,
1976 1979 1982 1985 1933 1991 1994 1997 2000 2003 2006
Source: U.S. BEA (2010b).
Second, The fact that the US's money multiplier and velocity are greatly dictated by foreign agents because of the dollar hegemony has rendered the federal reserve increasingly recovery. As Zerohedge's research notes (through the Fed's Bloomberg FOIA release), the majority of the dollars generated by QE2 European banks) instead of the US banks. Among the 20 Primary Dealers Contrary to what has been widely speculated, the bulk of risk asset
12 are foreign.
ineffective as a domestic central bank, especially in the time of
have been tunneled to foreign banks(especially currently recognized by the New York Fed,
purchasing by dealer desks has been performed by these US-based foreign primary dealers. All this is facilitated by the powerful Eurodollar market which accounts for nearly 90% of all international loans by 1997.
The Eurodollar market provides a vehicle enabling a skewing of reserve balances towards foreign banks operating in the US during the QE. Foreign banks operating in the US often lend reserves to home offices or other banks operating outside the US. Foreign banks operating in the US do not present a large source of C&I, Consumer, or Real Estate Loans. These banks represent about 16% of commercial bank assets, but only about 9% of bank credit. Thus, the concern that excess reserves will quickly fuel lending activities and money growth is probably diminished by the skewing of excess reserve balances towards foreign banks.
Cash Assets Of Foreign Banks ($ MM)
Cash Of Small/Large Domestic And Foreign Banks Vs Fed Bank Reserves ($MM)
As to how the dollars from QE2 went to foreign banks operating in the US, Stone McCarthy's research notes:Effectively affiliated foreign branch of a US bank (whether a domestic or foreign institution) would borrow dollars in the Eurodollar market. A Eurodollar is nothing more than a dollar denominated Eurodollar deposit will ultimately have a dollar denominated holds reserve balances at their local Federal Reserve Banks. When Eurodollar deposits move from one foreign bank to another, the claim against the original US bank follows the Eurodollar deposit. deposit at a bank outside the US. The bank holding the
claim against a bank domiciled in the US. That US bank in turn
If a bank domiciled in the US borrows dollars from a bank outside the US, including its own foreign branch, effectively what happens is the reserve balance of the US bank underpinning the Eurodollar account is reduced, and the reserve account of the borrowing bank in the US is increased. Overall US bank reserves are left unchanged, but the distribution of those reserves is changed from one bank in the US to
another, possibly even from the books of one Federal Reserve Bank to another. This also resolves the mystery why the US bank lending is still stagnant even though the Fed has pumped so much money into the system. Below are the chart of the total cash holdings of Foreign-related banks in the US using weekly H.B data.
Cash Assets Of Foreign Banks ($ MM)
The $630 billion increase in foreign bank cash balances since November 3, which just so happens to be the date when the Fed commenced QE2 operations in the form of adding excess reserves to the liability side of its balance sheet. Here is the change in Fed reserves during QE2 (from the Fed's HA.1 statement, ending with the week of June 1).
Reserve Balance with Federal Reserve Banks ($MM)
Source; Zero Hedge
Above, note that Fed reserves increased by $610 billion for the duration of QE2 through the week ending June 1 (and by another $70 billion in the week ending June 8, although since we only have bank cash data through June 1, we use the former number, although we are certain that the bulk of this incremental cash once again went to foreign financial institutions). So how did cash held by US banks fare during QE2? Well, not good. The chart below demonstrates cash balances at
small and large US domestic banks, as well as the cash at foreign banks, all of which is compared to total Federal reserves plotted on the same axis. It is obvious that most of the dollars created by QE2 have come to the foreign banks.
Cash Of Small/Large Domestic And Foreign Banks Vs Fed Bank Reserves ($MM)
(ltH • ..u:;,',
S"UTce: Z ..~o Hedge
This is the curse of the dollar as the world reserve currency. With the powerful Eurodollar market and near-zero domestic interest rates, the federal reserve has become a rather impotent domestic central bank while the recovering US economy is struggling in a liquidity trap and dollar chases yield else where. The dollar hegemony has become increasingly fiscally and monetarily unsustainable system. The best candidate in this reconstruction is Euro. future and at best it can act as a flaws when it comes to the to the US itself. The dollar hegemony of global reserve currency
will come to an end by either a forceful market correction or a knowingly gradual reconstruction
RMB has no way joined in the race to be a world reserve currency in a foreseeable
regional invoicing currency among trading partners, because China has some insurmountable state control on the economic issues, over-manipulated
candidacy of a world reserve currency:a political structure sharing no aspiration with the democratic economies, powerful exchange rate, impotent law system to protect property rights, and as the world reserve currency along with fragile diplomatic relationships with many trading partners. Let's pray Europe will survive the current sovereign debt crisis so that Euro will one day be strong enough to share the decisive responsibility the US dollar. Please follow Money Game on Twitter and Facebook. Follow Dee Woo on Twitter.
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4 Comments eureka on Aug 24, 1 :07 PM said: This article was difficult to understand, probably because int'l econ is hard to understand.
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But we all know that the US dollar being reserve currency allows us to simply borrow money like their is no tomorrow and that will ultimately cause a great crashing sound. Some day.
Reply JaveeAhmed on Aug 25, 7:56 /WI said:
First of all, since the US debt is in dollars, the US has no need to default. The recent downgrading by S&P therefore had little effect. The US responded by not increasing, but decreasing the interest rates ewn furrher!
Rag as Offensive
The Global economic imbalance is made up of the Trade imbalance and the Exchange rate imbalance. For example, the exchange rate of Chinese Yuan is 1.7 times lower than its Purchasing Power Parity or the equilibrium rate. If the pegged currencies were to mow towards their equilibrium rate, imports by the US will become costlier and exports by the US and domestic production become more cornpetltive thereby reducing trade imbalance, US debt and also raise employment lewl in the US. The problem is therefore less with the US and more with the rest of the world and the solution also therefore lies with the rest of the world. China and other Asian count rues should allow their currencies to appreciate, if not to the extent of the PPP, then at least to a lewl where trade with the US is balanced.
Reply Giles Raymond DeMouro! on Aug 25, 11:25 /WI said:
Dee, I'd agree with most of your article, except that there is on my "ew no alternatiw to the US dollar at this moment in time, certainly not the Ragas Offensive Euro with its uncertain future. You are of course right that the role of the dollar as the dominant reserve currency, coupled with ewr growing purchases ofT-bills by China and Japan, actually encourage US deficit and debt. The US, howewr, was never in risk of defaulting: what happened is a congressional dispute, which could not haw happened in any other country since only in the US does rasing the debt limit requires a law. The reason why the US was newr at risk of defaulting was of course not in the country's budget-to-GDP and debt-to-GDP ratios which are abysmal, but in the market's knowledge of the immense material wealth of the US. This said this cannot go on for ewr and China and Japan will not be able to keep on buying T-Bills the value of which would keep on decreasing. As I said earlier China and Japan cannot afford to see the US market for their exports significantly to shrink. China is fast expanding its domestic market but this is no substitute as yet to exports to the US, both in quantity and in "ew of the fact that China, in spite of her huge currency reserves (mainly in US dollars, by the way), will need more and more foreign curreny to finance her ever growing needs in energy and raw materials, the Yuan not being in a position to act as an international currency. What of the Euro? It has been marred since its inception by the fact that though money emission and management belong to the ECB, fiscal policy belongs to the member states of the Eurozone. The EU tried to resobe this conundrum with the Maastricht "conwrgence criteria". Obvously this didn't work as Genmany and France, much before Greec dide, being at the same time the guilty parties (they exceeded the debt-to-GDP and deficit-to-GDP targets) and the judge, decided to absolve themselves from the mild punishment pro"ded for in the Maastricht Treaty. A large proportion of Eurozone gowrnments did the same, Greece being the only one, however, to fiddle with their national accounts. Came the 2008 financial and economic crisis, the shortage of liquidity which almost paralyzed economies, the need to refinance some banks, etc. The Eurozone (which is ot the whole of the EU) stumbled into a short and mild economic re"val which soon came to an end. Then push came to show and it became apparent that sewral Eurozone members could no longer pay their debts, straightforward default not being a possibility because of their Eurozone membership. What is Europe going to do? Not much. They can refinance Greece, Portugal, Ireland, but probably not Italy and Spain, not to mention France. Proposals that would transfer fiscal and budgetary policies to a central body are deemed politically unpalatable. Sarkozy has now come up with his "golden rule" whereby member countries would enshrine in their constitutions the principle of a balanced budget. Apart from the undesirability of enshrining economic policy in a constitution (something I strongly objected to in the US in the Reagan era for reasons of principle, not because I fa""r budget deficits), I don't see what this would change. Eurozone countries are already Treaty-bound by the Maastricht rules to maintain their deficit-to-GDP and debt-to-GDP ratios within defined limits, and they did not comply. What would happen if a Eurozone member state "olated its constitution by continuing with its budget deficit? Would someone go and arrest the Prime minister? This is just window dressing. Second Sarkozy initiative more or less supported by Angela Merlkel: set up an "economic gowmment of Europe", ie a body that would owrsee national economic policies. Unfortunately this looks wry much like another attempt by France to curb the independence of the ECB, ie the only body that because it is independent is almost blameless in this situation, with outgoing Gowrnor JC Trichet haling warned Eurozone member states again and again and haling put forward his own proposals for centralized fiscal owrsight. France with its Gaullist-nationalist heritage never fully came to terms with the ECB's independence, ewn though Trichet is French and was literally imposed on other Eurozone members by then French president Jacques Chirac. Third, there was the idea that the ECB could issue Eurobonds so as to refinance near-defaulting Eurozone members. This was rightly in my "ew rejected by Merlkel as it would mean that well-behawd Eurozone members would indefinitely pay for the deficits and debt of badly-behawd member states. You may observe there, Dee, that this not so different from China nd Japan endessly buying US T-bills ... In any ewnt in my "ew the Euro is doomed unless some form of economic recovery takes place soon, including in the most deficit-prone and indebted countries.
This is still possible altough the odds are not that good. This is of course a personailliew. What is obllious to me however is that without some form of centralized fiscal o""rsight by an independent body, the ECB for instance, the in-built contradiction of the Euro will not be resohed. The Euro is only a fair-weather currency. What of the US then? China and Japan are in a position to put pressure on the US. While raising interest rates may not be of immediate desirability, an end should be put to quantitative easing as it is endlessly downgrading the US dollar and therefore dollar-denominated T-Bills. China and Japan should also demand serious deficit-reduction measures. The Obama administration should ha"" been able to do this on its own, but it is clearly too weak. As to CVongress, they may bicker but understand the language of power. This would not be undue pressure as it is China's and Japan's future which is at stake, just as well ast the US's. In my lliew there is still no altarnativa to the US dollar as the dominant resen.e currency, for all the above reasons and then some.
Woo (URL) on Aug 25,12:50
@Giles Raymond DeMourot: Giles,your analysis is truly significant, especially on Euro crisis. Eurobonds will do no good for Germany and France. It will no doubt dri"" up the broad bonrowing cost there. And that's a punishment for countries like Germany with sound fiscal standing.
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