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2011: The Year Ahead - Where now for the once mighty greenback?

QE2 | 2011: The Year Ahead - Where now for the once mighty greenback? Ian Fraser and Anthony Harrington

The US has benefited enormously from the use of the global reserve currency as its domestic currency and from the blindness of most bond investors to the true scale of the fiscal mountain that Washington must climb, in terms of the country’s unsustainable deficits. The myopia of investors has of course been exacerbated by the (US-based) credit ratings agencies which have continued to turn a blind eye to reality while slapping Treble-A ratings on US sovereign debt.

The effect of all this has been to put the US in a protective bubble, in which yields on US debt have remained remarkably low (in other words, the US government has been living in a fool’s paradise of ultra low debt-servicing costs compared to better-managed and more solvent countries). However economists and investors are increasingly warning that America is in for a rude awakening in 2011.

Bill Gross, managing director of bond investors Pimco, warns that “all investors should fear the consequences of mindless US deficit spending as far as the mantis eye can see. Higher inflation, a weaker dollar and the eventual loss of America’s AAA sovereign credit rating are the primary consequences. Fear your head - fear your head.”

Stephen King, chief economist at HSBC, believes that in 2010 the US benefited hugely from the uncertainty over Europe. Writing in the Independent, King said:

“The US finds itself in a very fortunate position. As the issuer of the world's dominant reserve currency, it has become a magnet for anxious and insecure investors who spend their time wondering whether the euro will ever survive. Even though Washington has yet to come up with a plan for fiscal consolidation, creditors the world over have mostly been happy to carry on lending to the US government.”

But he said investors may well change their tune about the credit risks associated with lending to the US in 2011.

“The danger comes not from the remote possibility of an outright sovereign default, but rather from the increased probability of a major dollar collapse. The Federal Reserve is, after all, printing lots of extra dollars in a bid to kick-start the US economy recovery. All those extra dollars will serve only to depress its value, underlining the risks foreign creditors are taking in holding Treasuries and other US dollar assets.

King said the US’s leading creditors who include China, Russia and Saudi Arabia “have a collective interest in moving the world to a new monetary order, one which is not so heavily dependent on the US dollar.” He also highlighted remarks from Russian president Dmitry Medvedev and prime minister Vladimir Putin and from the Chinese leadership, in which they expressed concern about having a dollar-based world financial system.

Emerging countries’ concerns were heightened when Federal Reserve chairman Ben Bernanke embarked on QE2 - a $600bn round of quantitative easing (or “money printing”) - in October 2010. They portrayed this as a form of economic terrorism that would cause surplus countries that lend money to the US to suffer financially, since their US assets would be devalued (dollar debasement is widely seen as one of the consequences of QE2). They also feared it would unleash a flood of “hot money” with inflationary consequences for emerging market economies. Last but not least they felt QE2 would undermine emerging market competitiveness, given the expected fall in the dollar.

In a recent interview Euan Munro, head of multi-asset investing at Standard Life Investments implied that the US is seeking to cope with its massive debt burden through dishonest means.

"The bond market is focusing on growth expectations and inflation expectations, and outside the eurozone, it is not paying sufficient attention to the fiscal rectitude of various governments. So for example the US fiscal deficit will be 11% or even 12% of GDP, yet their bonds are substantially cheaper because of QE2 etc, than those of governments like Australian or Canada where you’ve got more solvent governments that don’t have fiscal deficits, that will definitely be able to repay their debt using honest means.

"The US is playing quite a tough game - they are focusing on domestic growth and doing what’s good for America and the rest of the world will have to mind its eye."

HSBC’s King said emerging nations may struggle to detach themselves from the dollar:

“While it is possible to imagine a new world order where an increasing number of nations choose to conduct their international business in renminbi or roubles, this is not going to happen overnight. We know from the collapse of the gold standard in the inter-war years, and the break-up of the Bretton Woods system of fixed but adjustable exchange rates in the early 1970s, that the disintegration of an existing international monetary order can be a very messy affair."

Overall, King believes America is deluding itself if it believes it can deflate itself out of its own financial weakness, and predicts that it won’t be too long before the dollar and US hegemony starts to unravel:

"It is tempting to think – and certainly many Americas not surprisingly do – that a major dollar decline could provide an escape route for the US economy. It would do nothing of the sort. A weaker dollar would ultimately increase the costs to the US of accessing international capital markets and, of course, increase the cost to American consumers of all those imports. And, by debasing its currency, the US would be revealing its true colours: a nation addicted to debt and unable to live within its means. Symbolically, this would surely be the most unsettling message.

"[...] the US will no longer be able to claim to be the role model for others to look up to in a mixture of admiration and fear. Nations elsewhere in the world will increasingly head eastwards to secure their economic interests and, as they do so, China will increasingly challenge the US for economic and political supremacy."

There are a couple of technical arguments as to why quantitative easing has failed to have any immediate impact on US inflation. The principle one is that the traditional “money multiplier” effect, which would otherwise convert Bernanke’s $600 billion plus into a few trillion additional dollars washing around the US economy, has failed to kick in. Bank credit essentially creates new money and the Fed usually gets the banks going by handing them new “seed” money.

The banks then lend multiples of this to businesses, generating profits for themselves and pumping up their balance sheets, which in turn prompts them to look for higher yield, and off we go again into bubble formation territory.

However, the US now has the double-whammy of banks which are unprepared to lend and corporates that are unprepared to borrow. Many are so chastened by the crisis they prefer to keep cash on their balance sheets than avail themselves even of the existing facilities. As a result Bernanke’s fiscal stimuli are bypassing the real economy.

With the money multiplier currently being well strangled, it is hard to see US inflation getting off the ground. Then add in a sluggish economy that still has a real unemployment rate of 17% and you have overcapacity hammering any inflationary effort that tries to get going. How all this will change is entirely unclear, which is why Bernanke is threatening to emulate the Bank of Japan and widen out the Fed’s buying programme to include Exchange Traded Funds, which would be an eye-popping manoeuvre indeed.

Treasury Secretary Tim Geithner also recently told Congress that he wants to raise the US’s debt ceiling from its current level of $14.3 trillion. He warned congressmen that any failure to do so could prompt a US default as soon as March 2011, with "catastrophic economic consequences."

If the Fed starts to get frustrated with the muted impact of QE2 as we go deeper into 2011, investors who are nervous about US debt will have their anxiety heightened. Will this be the impetus the world needs to move beyond the dollar as the global reserve currency? We suspect not, but expect some convincing sabre-rattling in the months ahead.

Further reading on QE2 and the US economy:

Tags: banking , central banks , currency wars , economic recovery , QE2 , quantitative easing , US
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  1. AnthonyHarrington says:
    Fri Jul 15 12:52:57 BST 2011

    Bill, I believe you might find it interesting to look at my blog posted some seven months after your comment, "Why reform of the IMS tops the list of 10 impossible things..." I'd be interested in your thoughts...
  2. Bill Sharon says:
    Mon Jan 10 21:21:22 GMT 2011


    While the scope of your analysis is thorough I'm afraid that your conclusions reflect a wish and a hope. The reason that an alternative reserve currency has not emerged is that the alternatives don't inspire much confidence - nor do those advocating an alternative (Russia, China and Saudi Arabia). The monetary situation is untenable but no one can envision a viable solution. I would expect that we won't get through the year with only some sabre rattling. I would suggest that we will likely experience a succession of events outside of the monetary and financial systems that will result in a shock to those systems. We have demonstrated that we don't have the collective will to deal with the problems that the experts you quote are so facile in explaining. I don't foresee a change in that ability but to assume that we will somehow muddle through is, I believe, the least likely outcome.

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