A Level Economics Essay 12: Current Account Evaluation

 Evaluate the view that a current account surplus is always beneficial to an economy.

The view that a current account surplus is always beneficial to an economy may not be valid and depends on various factors. While a current account surplus can bring certain advantages, it is not necessarily always beneficial. Let's evaluate this view by considering both the advantages and potential drawbacks:

Advantages of a current account surplus:

1. Increased savings and investment: Germany, known for its current account surplus, has a high savings rate. This surplus of savings allows Germany to invest in research and development, infrastructure projects, and education, which contributes to its strong economic performance and technological advancements.

2. Foreign investment and capital inflows: China has experienced significant capital inflows as a result of its current account surplus. Foreign investors have been attracted to China's growing economy and have invested in various sectors, such as manufacturing, technology, and services, contributing to China's rapid economic expansion.

3. Strengthened financial position: Japan has historically maintained a current account surplus and accumulated substantial foreign reserves. These reserves have helped Japan weather economic downturns, provide stability to its financial system, and enhance its reputation as a reliable borrower in international markets.

Drawbacks of a current account surplus:

1. Currency appreciation and reduced competitiveness: Switzerland's persistent current account surplus has led to significant appreciation of the Swiss franc. This has made Swiss exports more expensive and challenged the competitiveness of industries like manufacturing, tourism, and watchmaking.

2. Declining domestic demand: Germany's heavy reliance on exports and its current account surplus have resulted in relatively low levels of domestic investment and consumption. This has led to criticisms that Germany's surplus comes at the expense of its domestic economy, limiting domestic demand and hindering the development of certain industries.

3. Imbalance in trade relationships: China's large current account surplus has triggered concerns from its trading partners, particularly the United States. The perceived unfair trade practices, such as intellectual property theft and currency manipulation, have strained trade relationships and prompted trade disputes between the two countries.

4. Missed investment opportunities: Japan's persistent current account surplus has been accompanied by relatively low levels of domestic investment. Critics argue that Japan should allocate more resources toward domestic sectors like innovation, entrepreneurship, and renewable energy to enhance long-term growth prospects.

These real-world examples demonstrate that while current account surpluses can bring benefits, they also present challenges. It is crucial for policymakers to carefully manage and address the implications of sustained surpluses to ensure a balanced approach to economic growth and development.

A history of global reserve currencies

Michael Pettis in The FT

The US dollar, analysts often propose, is the latest in a 600-year history of global reserve currencies. Each of its predecessor currencies was eventually replaced by another, and in the same way the dollar will eventually be replaced by one or more currencies.  

The problem with this argument, however, is that there is no such history. The role of the US dollar in the global system of trade and capital flows is unprecedented, mainly because of the unprecedented role the US economy plays in global trade and capital imbalances. The fact that so many analysts base their claims on this putative history only shows just how confused the discussion has been.  

It’s not that there haven’t been other important currencies before the dollar. The history of the world is replete with famous currencies, but these played a very different role in the flow of capital and goods across international borders. Trade before the days of dollar dominance was ultimately settled in gold or silver. A country’s currency could only be a “major” trade currency to the extent that its gold and silver coins were widely accepted as unadulterated or, by the 19th century, if the convertibility of its paper claims into gold or silver was highly credible.  

This is not just a technical difference. A world in which trade is denominated in gold or silver, or in claims that are easily and quickly convertible into gold and silver, creates very different conditions from those today. Consider the widely-held belief that sterling once ruled the world in much the same way the dollar does today.  

It simply isn’t true. While sterling was indeed used more than other currencies in Europe to settle trade, and the credibility of its conversion into gold was hard-earned by the Bank of England after the Napoleonic wars, whenever sterling claims rose relative to the amount of gold held by the Bank of England, its credibility was undermined. In that case foreigners tended to reverse their use of sterling, forcing the Bank of England to raise interest rates and adjust demand to regain gold reserves.¹ 

This does not happen to the US dollar. Trade conditions under gold- or silver-standards are dramatically different from those in a dollar world in at least three important ways. First, trade imbalances in the former must be consistent with the ability of economies to absorb gold and silver inflows and outflows. This means that while small imbalances were possible to the extent that they allowed wealthier economies to fund productive investment in developing economies, this was not the case for large, persistent trade imbalances — except under extraordinary circumstances.²  

Second, and much more importantly, as trade imbalances reverse, the contraction in demand required in deficit countries is matched by an expansion in demand in surplus countries. That is because while monetary outflows in deficit countries force them to curtail domestic demand to stem the outflows, the corresponding inflows into the surplus countries cause an automatic expansion of domestic money and credit that, in turn, boosts domestic demand. Under the gold- and silver-standards, in other words, trade imbalances did not put downward pressure on global demand, and so global trade expansion typically led to global demand expansion. 

And third, under gold and silver standards it was trade that drove the capital account, not vice versa as it is today. While traders chose which currency it was most convenient in which to trade, shifting from the use of one currency to another had barely any impact on the underlying structure of trade. 

None of these conditions hold in our dollar-based global trading system because of the transformational role played by the US economy. Because of its deep and flexible financial system, and its well-governed asset markets, the US — and other anglophone economies with similar conditions, eg the UK, Canada, and Australia — are the preferred location into which surplus countries dump their excess savings. 

Contrary to traditional trade theory, in which a well-functioning trading system might involve small, manageable capital flows from advanced, capital-intensive economies to capital-poor developing economies with high investment needs, nearly 70-80 per cent of all the excess savings — from both advanced and developing economies — is directed into the wealthy anglophone economies. These in turn have to run the corresponding deficits of which the US alone typically absorbs more than half. As I have discussed elsewhere, this creates major economic distortions for the US and the other anglophone economies, whose financial sectors benefit especially at the expense of their manufacturing sectors. 

It is only because the US and, to a lesser extent, the anglophone economies, are willing to export unlimited claims on their domestic assets — in the form of stocks, bonds, factories, urban real estate, agricultural property, etc — that the surplus economies of the world are able to implement the mercantilist policies that systematically suppress domestic demand to subsidise their manufacturing competitiveness. This is precisely what John Maynard Keynes warned about, unsuccessfully, in 1944. He argued that a dollar standard would lead to a world in which surplus and deficit countries would adjust asymmetrically, as the former suppressed domestic demand and exported the resulting demand deficiency. 

The point is that dollar dominance isn’t simply about choosing to denominate trading activities in dollars the way one might have chosen, in the 19th century, between gold-backed franc, gold-backed sterling, or Mexican silver pesos. It is about the role the US economy plays in absorbing global savings imbalances. This doesn’t mean, by the way, that the US must run permanent deficits, as many seem to believe. It just means that it must accommodate whatever imbalances the rest of the world creates. 

In the fifty years characterised by the two world wars, for example, the US ran persistent surpluses as it exported savings. Because Europe and Asia at the time urgently needed foreign savings to help rebuild their war-torn economies, it was the huge US surpluses that put the dollar at the centre of the global trading system during that period. 

By the 1960s and 1970s, however, Europe and Asia had largely rebuilt their economies and, rather than continue to absorb foreign savings, they wanted to absorb foreign demand to propel domestic growth further. Absorbing foreign demand means exporting domestic savings, and because of its huge domestic consumer markets and safe, profitable and liquid asset markets, the obvious choice was the US. Probably because of the exigencies of the cold war, Washington encouraged them to do so. Only later did this choice congeal into an economic ideology that saw unfettered capital flows as a way to strengthen the power of American finance. 

This is why the end of dollar dominance doesn’t mean a global trading system that simply and non-disruptively shifts from denominating trade in dollars to denominating it in some other currency. It means instead the end of the current global trading system — Ie the end of the willingness and ability of the anglophone economies to absorb up to 70-80 per cent of global trade surpluses, the end of large, persistent trade and capital flow imbalances, and, above all, the end of mercantilist policies that allow surplus countries to become competitive at the expense of foreign manufacturers and domestic demand. 

The end of dollar dominance would be a good thing for the global economy, and especially for the US economy (albeit not, perhaps, for US geopolitical power), but it can’t happen without a transformation of the structure of global trade, and it probably won’t happen until the US refuses to continue absorbing global imbalances as it has for the past several decades. However it happens, a world in which trade isn’t structured around the dollar will require a massive transformation of the structure of global trade — and for surplus countries like Brazil, Germany, Saudi Arabi, and China, this is likely to be a very disruptive transformation. 

1. Nor was sterling even the leading trade currency in the 18th and 19th centuries. More widely used in much of Asia and the Americas were Mexican silver pesos, whose purity and standardisation were much valued by traders and so formed the bulk of trade settlements. 

2. One can argue that the closest comparison to today was 17th century Spain, when Spain ran large, persistent trade deficits, but of course these were the automatic consequences of huge inflows of American silver, and Spain didn’t accommodate foreign imbalances so much as create them, to the benefit especially of England and the Netherlands. In a recent conversation George Magnus also noted how the famous sterling balances of the 1940s illustrated another — very different — example in which the structure of trade could not be separated from the use of its underlying currency.  

Governments can borrow more than was once believed

 From The Economist

 

If people know one thing about the thinking of John Maynard Keynes, who more or less founded macroeconomics, it is that he was in favour of governments borrowing lots of money, at least under some circumstances. The “New Keynesian” orthodoxy that evolved from his work in the second half of the 20th century was much less liberal in this regard. It put less faith in borrowing’s purported benefits, and had greater concerns about its dangers.

The 2010s saw the pendulum swinging back. In large part because they feel bereft of other options, many governments have borrowed heavily—and as yet they have paid no dreadful price. Can this go on?

Keynes’s ideas about borrowing reflected his view of recessions—and in particular, the Depression of the 1930s, during which he wrote “The General Theory of Employment, Interest and Money”—as vicious circles. Recessions come about when the economy is hit by a sudden rise in the desire to save money; such desires lead to lower spending, which leads to more unemployment, which leads to yet less spending, and so on. If the government borrows enough to offset lower private spending with increased spending of its own the circle can be broken—or stopped from getting going.

Most early Keynesians assumed that the deficits caused by borrowing to stimulate the economy would be temporary; after borrowing more than they raised in taxes in order to provide a fiscal stimulus, governments would be able to raise more in taxes, and thus pay off their debts, in the good times that followed. Some, though, suspected that the structure of the advanced economies of the 1930s might mean they were low on demand even in the good times, and that a permanent deficit might be necessary to keep the economy going at a rate that minimised unemployment.

Debates about the proper role of fiscal stimulus became less urgent in the decades after the second world war, as robust economic growth eased worries that demobilisation might bring a return of Depression-like conditions. Faith in Keynesian orthodoxy was further shaken by the economic developments of the 1970s and 1980s. Some economists began to argue that the public would eventually adjust to stimulus measures in ways that weakened their impact. Robert Barro, a leading proponent of this “rational expectations” approach, argued that a fiscal stimulus paid for by borrowing would see households spend less and save more, because they would know that tax rises were coming. This decreased private spending would then offset the increased public spending.

Linked to, but broader than, such academic questions was the fact that, by the 1970s, the ways in which Keynesian governments had been running their economies seemed to have failed. A trifecta of slowing growth, soaring inflation and high unemployment brought the idea of governments being able to avoid recessions through stimulus into disrepute.

The new orthodoxy was that governments should instead rely on monetary policy. When the economy slowed, monetary policy would loosen, making it cheaper to borrow, thus encouraging people to spend. Government borrowing, for its part, should be kept on a short leash. If governments pushed up their debt-to-gdp ratio, markets would become unwilling to lend to them, forcing up interest rates willy-nilly. The usefulness of monetary policy demanded a sober approach to fiscal policy.

The 2000s, however, saw a problem with this approach beginning to become plain. From the 1980s, interest rates had been in a long, steady decline. By the 2000s they had reached historical lows. Low rates made it harder for central banks to stimulate economies by cutting them further: there was not room to do so. The global financial crisis pushed rates around the world to near zero.

Governments experimented with more radical monetary policy, such as the form of money printing known as “quantitative easing”. Their economies continued to underperform. There seemed to be room for new thinking, and a revamped Keynesianism sought to provide it. In 2012 Larry Summers, a former American treasury secretary, and Brad DeLong, an economist, suggested a large Keynesian stimulus based on borrowing. Thanks to low interest rates, the gains it would provide by boosting the growth rate of gdp might outstrip the cost of financing the debt taken on.

In the following year Mr Summers followed some 1930s Keynesians, notably Alvin Hansen, in suggesting that borrowing in order to stimulate might be needed not just as an occasional pick-me-up, but as a permanent part of the economy. Hansen had argued that an ageing population and a low rate of technological innovation produced a long-term lack of demand which he called “secular stagnation”. Mr Summers took an updated but similar view. Part of his backing for this idea was that the long-term decline of interest rates showed a persistent lack of demand.

Way down we go

Sceptics insisted that such borrowing would drive interest rates up. But as the years went by and interest rates remained stubbornly low, the notion of borrowing for fiscal stimulus started to seem more tenable, even attractive. Very low interest rates mean that economies can grow faster than debt repayments do. Negative interest rates, which have been seen in some countries over recent years, mean that the amount to repay will actually be less than the amount borrowed.

Adherents of “Modern Monetary Theory” (mmt) went further than this, arguing that governments should borrow as much as was needed to achieve full employment while central banks focused simply on keeping interest rates low—a course of action which orthodox economics would expect to promptly drive up inflation. Currently mmt remains on the fringes of academic economics. But it has been embraced by some left-wing politicians; Senator Bernie Sanders, the candidate beaten by Joe Biden for the Democratic nomination, counted an mmt enthusiast, Stephanie Kelton of Stony Brook University, among his chief advisers.

The shift in mainstream thinking on debt helps explain why the huge amounts of government borrowing with which the world has responded to the pandemic has not worried economists. But now that governments have, if only for want of an alternative, become more willing to take on debt, what should be their limit? For an empirical answer, it is tempting to consider Japan, where the ratio of net public debt to gdp stood at 154% prior to the pandemic.

If Japan can continue to borrow with that level of debt, it might seem that countries with lower levels should also be fine. But this ignores the fact that if interest rates stagger back from the floor, burdens a lot smaller than Japan’s might become perilously unstable. There is no immediate account for why this might be likely. But that does not mean it will not happen. And governments need to remember that debt taken on at one interest rate may, if market sentiment changes, need to be rolled over at a much higher one in times to come.

Given this background risk, governments ideally ought to make sure that new borrowing is doing things that will provide a lasting good, greater than the final cost of the borrowing. If money is very cheap and likely to remain so, this will look like a fairly low bar. But there are opportunity costs to consider. If private borrowing has a high return and public borrowing crowds it out, then the public borrowing either needs to show a similarly high return or it needs to be cut back.

At the moment private returns remain well above the cost of new borrowing in most places: in America, for instance, the earnings of corporations are generally high relative to the replacement cost of their capital. This makes it conceivable that resources used by the government would generate a greater level of welfare if they were instead mobilised by private firms.

But it does not currently look as though they would be. Despite the seemingly high returns to new capital, private investment in America is quite low. This suggests either that there are other obstacles to new investment, or that the high returns on investment reflect an insufficient level of competition rather than highly productive companies.

Both possibilities call for government remedy: either action aimed at identifying and dismantling the obstacles to investment, or at increasing competition. And until such actions produce greater investment or lower returns, the case for government borrowing remains quite strong. This is even more the case for public investments which might in themselves encourage the private sector to match them—“crowding in”, as opposed to crowding out. Investment in a much better electricity grid, for example, could increase investment in zero-carbon generation.

In the long run, the way to avoid having to borrow to the hilt is to implement structural changes which will revive what does seem to be chronically weak demand. Unfortunately, there is no consensus over why demand is weak. Is technological progress, outside the realm of computers and communications, not what it was? Is inequality putting money into the hands of the rich, who are less likely to spend their next dollar, rather than the poor, who are more likely? Are volatile financial markets encouraging precautionary saving both by firms and governments? Is the ageing of the population at the root of it all?

Making people younger is not a viable policy option. But the volatility of markets might be addressed by regulation, and a lack of competition by antitrust actions. If inequality is at the root, redistribution (or its jargony cousin, predistribution) could perk up demand. Dealing with the structural problems constraining demand would probably push up interest rates, creating difficulties for those governments which have already accumulated large debt piles. But stronger underlying growth would subsequently reduce the need for further government borrowing, raise gdp and boost tax revenues. In principle that would make it easier for governments in such situations to pay down their increased debt.

The new consensus that government borrowing and spending is indeed an important part of stabilising an economy, and that interest rates are generally low enough to allow governments to manage this task at minimal cost, represents progress. Government borrowing is badly needed to deal with many of the world’s current woes. But this consensus should ideally include two additional planks: that the quality of deficit-spending still matters, and that governments should prepare for the possibility of an eventual change in the global interest-rate environment—much as 2020 has shown that you should prepare for any low-probability disaster. 

Deficits can matter, sometimes

Philip Coggan in The FT

Deficits don’t matter. This quote comes not from some spendthrift European socialist but reputedly from the distinctly conservative Dick Cheney, vice-president of the US from 2001 to 2009. 

According to an account by former Treasury secretary Paul O’Neill, in 2002 Cheney cited the Reagan administration as evidence for his thesis; the national debt tripled on the Republican’s watch in the 1980s but the US economy boomed and bond yields fell sharply. 

In the 20 years since Cheney’s remark, US federal debt has roughly doubled as a proportion of GDP. But 10-year Treasury bond yields are no higher than they were two decades ago; indeed they have spent much of the intervening period at much lower levels, even as debt has soared. The continuing brouhaha over the US debt ceiling has nothing to do with the willingness of markets to buy American debt; any everything to do with the willingness of politicians to honour their government’s commitments. 

However, Cheney’s sentiments have not always been borne out elsewhere. Over the past nine months the British government has discovered the problems that can occur when funding costs suddenly increase. And that has rekindled the debate over the ability of governments to run prolonged deficits. 

In one camp are the spiritual descendants of Margaret Thatcher, the former British prime minister who sought to balance budgets, arguing that “good Conservatives always pay their bills”. Modern budget hawks often say that governments should not pass on the burden of debt repayment to the next generation. Many also argue that budget deficits are caused by excessive government spending and that reducing this spending is not only prudent but will fuel economic growth. In the other camp are the majority of economists, who argue that unlike individuals, governments are in effect immortal and can rely on inflation, or future generations, to pay down their debts. 

They point out that government debt, as a proportion of gross domestic product, was very high (in both the US and the UK) in the aftermath of the second world war. That debt proved no barrier to rapid economic growth. Furthermore, ageing populations in the developed world mean there has been a “savings glut” as citizens put aside money for their retirements, making it easy to fund deficits. 

But the freedom of governments to issue debt comes with a couple of caveats. First, a country must be able to issue debt in its own currency. Many a developing country has discovered the dangers of issuing debt in dollars. If that country is forced to devalue its currency, then the cost of servicing the dollar debt soars. Secondly, countries need a central bank that is willing to support its government by buying its debt. The quantitative easing programmes of such buying has undoubtedly made it easier for governments to run deficits. 

In the eurozone crisis of 2010-12, deficits did matter for countries like Greece and Italy. Their bond yields soared as investors feared that the indebted countries might be forced to leave the eurozone. This would have either forced governments to default, or attempt to re-denominate the debt into their local currency. Greece turned to neighbours for help but found that other countries were unwilling to provide required support that unless Athens reined in its budget deficits. 

To many Eurosceptics, that proved the folly of joining the single currency. Britain was free of such constraints since it issued debt in its own currency and had a central bank that would undertake QE. Given those freedoms, the financial crisis of last autumn, which followed the mini-Budget proposed by the shortlived Liz Truss administration, was even more of a shock. 

While Truss tried to echo Thatcher’s imagery, she rejected the budgetary prudence of the Treasury as “abacus economics”. She argued that slashing taxes would lead to faster economic growth so that the deficit would disappear of its own accord as government revenues rose.  

However, the markets did not swallow the argument. The mini-Budget was followed by a spectacular sell-off in sterling and UK government bonds. The latter may have stemmed from the leveraged bets made by British pension funds on bonds. Still, the Truss team’s economic analysis failed to account for this possibility. 

Investor confidence in British economic policy had already been dented by the Brexit vote and by the rapid turnover of prime ministers and chancellors. The problem has not gone away. Data released this week showed that Britain was still struggling to contain inflation and gilt yields jumped back towards the levels reached after the mini-Budget. 

So Cheney’s aphorism needs amending. Deficits don’t matter if the government borrows in its own currency, and also has a friendly central bank, a steady inflation rate and the confidence of the financial markets. It also requires a continuation of the global savings glut. Those conditions mean there is plenty of scope for future governments to get into trouble.

Is De-Dollarisation on the Cards? Can the Yuan or a BRICS currency replace the US Dollar?

 

Interpreting the Putin Xi Meet - An Indian Perspective

 

What is a Default - A Pakistan Scenario

Asad Ejaz Butt in The Dawn

When Pakistan’s dollar reserves fell below $5 billion in December, and its credit default risk had reportedly become too high for analysts to ignore the possibility of an imminent default, the central bank made a policy decision to allow the opening of import letter of credits (LC) in a staggered manner to ensure spreading of the dollar reserve over a longer period of importing time.

The idea was to allow the government some diplomatic time to knock on the doors of friendly countries and multilateral organisations, including the International Monetary Fund (IMF). The Fund had dilly-dallied on the ninth review to force monetary authorities in Pakistan to take the first steps towards a few baseline reforms, including the relegation of the dollar to the markets. Markets that the central bank and the government regards as ripe with imperfections.

The rupee was finally devalued last week which automatically implied that it was left to a market that had the propensity to sell it to gain dollars. This provided IMF with the confidence to schedule the ninth review, which is now ongoing in Islamabad. It is likely that the IMF’s review will be completed, and default, as was predicted by some and wished by a few others, didn’t happen.

However, while the media thundered about the staggeringly high levels of inflation and alarmingly low levels of reserves, and analysts evaluated an infinitely large number of scenarios that would lead to a default, no one from the economists ever explained what a default meant and what would have happened to the economy if it took place. 

From the mid of November to the end of January, I was asked this question many times: “is Pakistan going to default, or has it already defaulted?” None of those asking the question seemed to know what it meant for a country to default and what would happen if it did. Last week, for the first time, someone asked me what Pakistan’s economy would have looked like under the influence of default.

Put in very simple terms, a default for a country like Pakistan with large exposure in commercial loans means defaulting against commercial debt. Bilateral debt can be rolled over, while debt from multilateral organisations often has long-term maturity cycles making a country’s default vulnerability depend primarily on commercial loans.

So, imagine if Pakistan’s reserves had declined to such low levels that it would have defaulted against its commercial debt. This would have led the central bank to refuse commercial lenders’ payments to repay or service their debt.

That would have reflected in the further downgrading of the country’s ratings by agencies like Moody’s and S&P, dampening the trust of other international lenders and, after that, the government’s ability to raise new commercial debt.

Since the dollar inflows would have declined due to limitations of debt inflows, you could have only imported as much as you exported plus the dollars that expat Pakistanis remit from all over the world. This would be like a situation where you are forced by circumstances to keep your current account deficit close to zero.

Many of the imports that you would not afford would be inputs to the industry. While that would impact exports, the slowdown would impact production in the non-exporting sectors, pulling down the overall level of production in the economy. The natural consequence of all of this is the classic saga of too much Pak­istani rupee chasing too few goods.

Inflation would have skyrocketed as the local currency that people would be holding would not translate into consumable items. Contraction in the economy due to production losses would have seen many people get laid off in a span of weeks, leaving some with money but nothing to buy and many without even money to buy. Economists call such situations characterised by slow growth but high unemployment and inflation ‘stagflation’.

This was played out in Sri Lanka in the summer of 2022. It suspended repayments on about $7bn of international loans due out of a total foreign debt pile of $51bn while it had $25m in usable foreign reserves.

Pakistan has around $3bn in reserves against an external debt pile of $126bn. Pakistan, in December 2022, was definitely headed in the Sri Lankan direction. However, we did not default and any chance of doing so has been left far behind.

Reviving even mere inches away from default is a world different to an actual default since, in the former case, you can resume business as usual as soon as a multilateral like the IMF returns with a few dollars in hand. However, in the latter case, even multilateral balance of payments support will take years to rebuild the economic edifice.

Pakistan didn’t default, and those who thought what happened to Pakistan in December of 2022 was a default must realise that a real default would have been much scarier than a few hundred LCs being opened with delay.

This piece is based on several conversations held with Mubashir Iqbal and Haider Ali.

The Rupee's Exchange Rate and Declining Dollar Reserves

 

A post-dollar world is coming

 The currency may look strong but its weaknesses are mounting writes Ruchir Sharma in The FT

This month, as the dollar surged to levels last seen nearly 20 years ago, analysts invoked the old Tina (there is no alternative) argument to predict more gains ahead for the mighty greenback. 

What happened two decades ago suggests the dollar is closer to peaking than rallying further. Even as US stocks fell in the dotcom bust, the dollar continued rising, before entering a decline that started in 2002 and lasted six years. A similar turning point may be near. And this time, the US currency’s decline could last even longer. 

Adjusted for inflation or not, the value of the dollar against other major currencies is now 20 per cent above its long-term trend, and above the peak reached in 2001. Since the 1970s, the typical upswing in a dollar cycle has lasted about seven years; the current upswing is in its 11th year. Moreover, fundamental imbalances bode ill for the dollar. 

When a current account deficit runs persistently above 5 per cent of gross domestic product, it is a reliable signal of financial trouble to come. That is most true in developed countries, where these episodes are rare, and concentrated in crisis-prone nations such as Spain, Portugal and Ireland. The US current account deficit is now close to that 5 per cent threshold, which it has broken only once since 1960. That was during the dollar’s downswing after 2001. 

Nations see their currencies weaken when the rest of the world no longer trusts that they can pay their bills. The US currently owes the world a net $18tn, or 73 per cent of US GDP, far beyond the 50 per cent threshold that has often foretold past currency crises. 

Finally, investors tend to move away from the dollar when the US economy is slowing relative to the rest of the world. In recent years, the US has been growing significantly faster than the median rate for other developed economies, but it is poised to grow slower than its peers in coming years. 

If the dollar is close to entering a downswing, the question is whether that period lasts long enough, and goes deep enough, to threaten its status as the world’s most trusted currency. 

Since the 15th century, the last five global empires have issued the world’s reserve currency — the one most often used by other countries — for 94 years on average. The dollar has held reserve status for more than 100 years, so its reign is already older than most. 

The dollar has been bolstered by the weaknesses of its rivals. The euro has been repeatedly undermined by financial crises, while the renminbi is heavily managed by an authoritarian regime. Nonetheless, alternatives are gaining ground. 

Beyond the Big Four currencies — of the US, Europe, Japan and the UK — lies the category of “other currencies” that includes the Canadian and Australian dollar, the Swiss franc and the renminbi. They now account for 10 per cent of global reserves, up from 2 per cent in 2001. 

Their gains, which accelerated during the pandemic, have come mainly at the expense of the US dollar. The dollar share of foreign exchange reserves is currently at 59 per cent — the lowest since 1995. Digital currencies may look battered now, but they remain a long-run alternative as well. 

Meanwhile, the impact of US sanctions on Russia is demonstrating how much influence the US wields over a dollar-driven world, inspiring many countries to speed up their search for options. It’s possible that the next step is not towards a single reserve currency, but to currency blocs. 

South-east Asia’s largest economies are increasingly settling payments to one another directly, avoiding the dollar. Malaysia and Singapore are among the countries making similar arrangements with China, which is also extending offers of renminbi support to nations in financial distress. Central banks from Asia to the Middle East are setting up bilateral currency swap lines, also with the intention of reducing dependence on the dollar. 

Today, as in the dotcom era, the dollar appears to be benefiting from its safe-haven status, with most of the world’s markets selling off. But investors are not rushing to buy US assets. They are reducing their risk everywhere and holding the resulting cash in dollars. 

This is not a vote of confidence in the US economy, and it is worth recalling that bullish analysts offered the same reason for buying tech stocks at their recent peak valuations: there is no alternative. That ended badly. Tina is never a viable investment strategy, especially not when the fundamentals are deteriorating. So don’t be fooled by the strong dollar. The post-dollar world is coming.

The US’s selfish war on inflation will tip the world into recession

Phillip Inman in The Guardian


As the Fed raises interest rates, dollar-denominated loans become an unsustainable burden to states around the globe

The Federal Reserve is planning a second interest rate rise in a year this month. Photograph: Chris Wattie/Reuters 


Later in July US interest rates are expected to jump for a second time this year, and that’s going to wreck any chance of a global recovery.

The Federal Reserve could push its base rate up by as much as a full percentage point, ending 15 years of ultra-cheap money, intended to promote growth.

This jump, to a range of 2.5%-2.75%, would take the cost of borrowing money in the US to more than double the Bank of England’s 1.25%. And yet the Fed could just be taking a breather as it contemplates even higher rates.

This column, though, is not about the US. It is concerned with the terrible impact on Britain and countries across the world of America’s selfish disregard when it decides to tackle high inflation with higher borrowing costs. Britain is already feeling the effects of the Fed’s pledge to tackle inflation until it is “defeated”, come what may.

Higher interest rates in the US make it a more attractive place for investors to store their money. To take full advantage, investors must sell their own currency and buy dollars, sending the price of dollars rocketing higher.

In July the US dollar increased in value against a basket of six major currencies to a 20-year high. The euro has slipped below parity with the dollar in the last few days. The pound, which has plunged by more than 10% this year to below $1.20, is losing value with every week that passes.

In Japan, the central bank has come under huge pressure to act after the yen tumbled to its lowest level against the dollar since 1998.

There are two important knock-on effects for those of us that live and work outside the US.

The first is that goods and raw material priced in dollars are much more expensive. And most commodities are priced in dollars, including oil.

Borrowing in dollars also becomes more expensive. And while getting a loan from a US bank is beyond the average British household, companies do it all the time, and especially those in emerging economies, where funds in their backyard can be in short supply.

The Bank of England interest-rate setter Catherine Mann recently said that her main motivation for wanting significant increases in the UK’s lending rates was her fear that the widening gap with the dollar was pushing up import prices. And higher import prices meant higher inflation.

If only she could persuade her colleagues on the Bank’s monetary policy committee that the devaluation of the pound was a serious issue, maybe they would push up the Bank’s base rate in line with the Fed rate increases. After the Fed makes its move, more may join her.

Until January this year, Britain’s inflation surge was on course to be short-lived. Now it seems the Russian invasion of Ukraine and a splurge of untargeted handouts by the Biden administration during the pandemic, which have served to push up prices in America, will keep inflation in the UK high into next year. 

Those governments that have borrowed in dollars face a double whammy. Not only will they need to raise domestic interest rates to limit the impact of import price rises, they will also face a massive jump in interest payments on their dollar borrowings.

Emerging markets and many developing-world countries will be broke when these extra costs are combined with a loss of tourism from the Covid pandemic. Sri Lanka has already gone bust and many more could follow.

For the past three decades, western banks have marketed low-cost loans across the developing world as a route to financial freedom.

Zambia’s government borrowed heavily before the pandemic to become self-sufficient in electricity. It is a laudable aim, but has left the central African state with a ratio of debt to national income (GDP) much the same as France’s – about 110%.

The problem for Zambia is not the same as for France, which pays an interest rate of 1.8% to finance its debts, measured by the yield on its 10-year bonds. The Zambian 10-year bond commands a rate of 27%. Now Zambia, like France and so many other countries, must borrow simply to live. To invest is to borrow more.

There is no sign that the US will change course. Joe Biden is in a panic about the midterm elections, when fears of spiralling inflation could favour the Republicans. This panic has spilled over to the Fed, which has adopted hysterical language to persuade consumers and businesses that higher rates are coming down the track and to curb their spending accordingly.

The Fed knows inflation is a problem born of insufficient supply that only governments can tackle. But that doesn’t look like stopping it from pushing the US economy, and everyone else’s, into recession.

Will dollar dominance give way to a multipolar system of currencies?

From The Economist

In the wake of an invasion that drew international condemnation, Russian officials panicked that their dollar-denominated assets within America’s reach were at risk of abrupt confiscation, sending them scrambling for alternatives. The invasion in question did not take place in 2022, or even 2014, but in 1956, when Soviet tanks rolled into Hungary. The event is often regarded as one of the factors that helped kick-start the eurodollar market—a network of dollar-denominated deposits held outside America and usually beyond the direct reach of its banking regulators.

The irony is that the desire to keep dollars outside America only reinforced the greenback’s heft. As of September, banks based outside the country reported around $17trn in dollar liabilities, twice as much as the equivalent for all the other currencies in the world combined. Although eurodollar deposits are beyond Uncle Sam’s direct control, America can still block a target’s access to the dollar system by making transacting with them illegal, as its latest measures against Russia have done.

This fresh outbreak of financial conflict has raised the question of whether the dollar’s dominance has been tarnished, and whether a multipolar currency system will rise instead, with the Chinese yuan playing a bigger role. To understand what the future might look like, it is worth considering how the dollar’s role has evolved over the past two decades. Its supremacy reflects more than the fact that America’s economy is large and its government powerful. The liquidity, flexibility and the reliability of the system have helped, too, and are likely to help sustain its global role. In the few areas where the dollar has lost ground, the characteristics that made it king are still being sought out by holders and users—and do not favour the yuan.

Eurodollar deposits illustrate the greenback’s role as a global store of value. But that is not the only thing that makes the dollar a truly international currency. Its role as a unit of account, in the invoicing of the majority of global trade, may be its most overwhelming area of dominance. According to research published by the imf in 2020, over half of non-American and non-eu exports are denominated in dollars. In Asian emerging markets and Latin America the share rises to roughly 75% and almost 100%, respectively. Barring a modest increase in euro invoicing by some European countries that are not part of the currency union, these figures have changed little in the past two decades.

Another pillar of the dollar’s dominance is its role in cross-border payments, as a medium of exchange. A lack of natural liquidity for smaller currency pairs means that it often acts as a vehicle currency. A Uruguayan importer might pay a Bangladeshi exporter by changing her peso into dollars, and changing those dollars into taka, rather than converting the currencies directly.

So far there has been little shift away from the greenback: in February only one transaction in every five registered by the swift messaging system did not have a dollar leg, a figure that has barely changed over the past half-decade. But a drift away is not impossible. Smaller currency pairs could become more liquid, reducing the need for an intermediary. Eswar Prasad of Cornell University argues convincingly that alternative payment networks, like China’s Cross-Border Interbank Payment System, might undermine the greenback’s role. He also suggests that greater use of digital currencies will eventually reduce the need for the dollar. Those developed by central banks in particular could facilitate a direct link between national payment systems.

Perhaps the best example in global finance of an area in which the dollar is genuinely and measurably losing ground is central banks’ foreign-exchange reserves. Research published in March by Barry Eichengreen, an economic historian at the University of California, Berkeley, shows how the dollar’s presence in central-bank reserves has declined. Its share slipped from 71% of global reserves in 1999 to 59% in 2021. The phenomenon is widespread across a variety of central banks, and cannot be explained away by movements in exchange rates.

The findings reveal something compelling about the dollar’s new competitors. The greenback’s lost share has largely translated into a bigger share for what Mr Eichengreen calls “non-traditional” reserve currencies. The yuan makes up only a quarter of this group’s share in global reserves. The Australian and Canadian dollars, by comparison, account for 43% of it. And the currencies of Denmark, Norway, South Korea and Sweden make up another 23%. The things that unite those disparate smaller currencies are clear: all are floating and issued by countries with relatively or completely open capital accounts and governed by reliable political systems. The yuan, by contrast, ticks none of those boxes. “Every reserve currency in history has been a leading democracy with checks and balances,” says Mr Eichengreen.
Battle royal

Though the discussion of whether the dollar might be supplanted by the yuan captures the zeitgeist of great-power competition, the reality is more prosaic. Capital markets in countries with predictable legal systems and convertible currencies have deepened, and many offer better risk-adjusted returns than Treasuries. That has allowed reserve managers to diversify without compromising on the tenets that make reserve currencies dependable.

Mr Eichengreen’s research also speaks to a plain truth with a broader application: pure economic heft is not nearly enough to build an international currency system. Even where the dollar’s dominance looks most like it is being chipped away, the appetite for the yuan to take even a modest share of its place looks limited. Whether the greenback retains its paramount role in the international monetary system or not, the holders and users of global currencies will continue to prize liquidity, flexibility and reliability. Not every currency can provide them. 

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Time for a great reset of the financial system

A 30-year debt supercycle that has fuelled inequality illustrates the need for a new regime writes CHRIS WATLING in The FT 

On average international monetary systems last about 35 to 40 years before the tensions they create becomes too great and a new system is required. 

Prior to the first world war, major economies existed on a hard gold standard. Intra-wars, most economies returned to a “semi-hard” gold standard. At the end of the second world war, a new international system was designed — the Bretton Woods order — with the dollar tied to gold, and other key currencies tied to the dollar. 

When that broke down at the start of the 1970s, the world moved on to a fiat system where the dollar was not backed by a commodity, and was therefore not anchored. This system has now reached the end of its usefulness. 

An understanding of the drivers of the 30-year debt supercycle illustrates the system’s tiredness. These include the unending liquidity that has been created by the commercial and central banks under this anchorless international monetary system. That process has been aided and abetted by global regulators and central banks that have largely ignored monetary targets and money supply growth. 

The massive growth of mortgage debt across most of the world’s major economies is one key example of this. Rather than a shortage of housing supply, as is often postulated as the key reason for high house prices, it’s the abundant and rapid growth in mortgage debt that has been the key driver in recent decades. 

This is also, of course, one of the factors sitting at the heart of today’s inequality and generational divide. Solving it should contribute significantly to healing divisions in western societies. 

With a new US administration, and the end of the Covid battle in sight with the vaccination rollout under way, now is a good time for the major economies of the west (and ideally the world) to sit down and devise a new international monetary order. 

As part of that there should be widespread debt cancellation, especially the government debt held by central banks. We estimate that amounts to approximately $25tn of government debt in the major regions of the global economy. 

Whether debt cancellation extends beyond that should be central to the negotiations between policymakers as to the construct of the new system — ideally it should, a form of debt jubilee. 

The implications for bond yields, post-debt cancellation, need to be fully thought through and debated. A normalisation in yields, as liquidity levels normalise, is likely. 

High ownership of government debt in that environment by parts of the financial system such as banks and insurers could inflict significant losses. In that case, recapitalisation of parts of the financial system should be included as part of the establishment of the new international monetary order. Equally, the impact on pension assets also needs to be considered and prepared for. 

Secondly, policymakers should negotiate some form of anchor — whether it’s tying each other’s currencies together, tying them to a central electronic currency or maybe electronic special drawing rights, the international reserve asset created by the IMF. 

As highlighted above, one of the key drivers of inequality in recent decades has been the ability of central and commercial banks to create unending amounts of liquidity and new debt.

This has created somewhat speculative economies, overly reliant on cheap money (whether mortgage debt or otherwise) that has then funded serial asset price bubbles. Whilst asset price bubbles are an ever-present feature throughout history, their size and frequency has picked up in recent decades. 

As the Fed reported in its 2018 survey, every major asset class over the 20 years from 1997 through to 2018 grew on average at an annual pace faster than nominal GDP. In the long term, this is neither healthy nor sustainable. 

With a liquidity anchor in place, the world economy will then move closer to a cleaner capitalist model where financial markets return to their primary role of price discovery and capital allocation based on perceived fundamentals (rather than liquidity levels). 

Growth should then become less reliant on debt creation and more reliant on gains from productivity, global trade and innovation. In that environment, income inequality should recede as the gains from productivity growth become more widely shared. 

The key reason that many western economies are now overly reliant on consumption, debt and house prices is because of the set-up of the domestic and international monetary and financial architecture. A Great Reset offers therefore opportunity to restore (some semblance of) economic fairness in western, and other, economies.