Tuesday, August 16, 2011

The appetite for American dollars

Amidst all the discussion, analysis, forecasts and alarm surrounding the credit downgrade of the United States,the soaring national debt  and potential default, an  obvious question is never being asked by anyone in the mainstream media establishment.  Why would any government want to hold onto US debt in the first place? This question is almost never addressed directly although issues surrounding it such as concern over foreigners funding America's consumption, debt-fueled spending and dangers of the possible run on the dollar are reported and discussed (even then, either incorrectly or hysterically or both). The explanation for this has to do with the fact that exploring that question and reaching to its logical conclusion would reveal the full extent of American economic imperialism for over 60 years and the rigging of the entire global reserve system around the dollar.

The question is so plainly obvious that it is conspicuous by its absence in any public debate. Why would any foreign nation want to stack up on Treasury securities when their yield is so low? All the more baffling when you consider that several under-developed and developing nations that are otherwise strapped for money have considerable dollar-denominated reserves piled up. Imagine if these nations could invest the same amount of money into a lucrative business, they could use the profit earned to fund domestic social services like healthcare and education. Why would a government not choose that more profitable option or alternately, use that same reserve for important developmental projects at home?  During those really rare occasions that this issue is considered in the mainstream American media, the usual explanation that is provided points to the fact that the US government debt is a safe haven for all investors. To bolster this position, we will be informed that at times of severe crisis and market shocks,such as, for example the collapse of Lehman Brothers and other large financial firms in August of 2008, investors were rushing to hoard Treasury notes because of their perceived low risk. The same pattern was observed, most oddly, immediately after Standard and Poor announced the downgrade of US debt recently.  There is, undeniably, a grain of truth to this claim but like so many other simple-minded blanket  explanations this still does not account for how willing governments to pay for America's extravagant ways (with so little ostensible benefit).

Bretton Woods System

The real answer goes back all the way to 1944 and to a small town in New Hampshire where the major Allied powers set out to lay the foundation of the future global economic system.   With the country clearly emerging as far and beyond the most powerful economic power whose future domination was obvious, the United States was able to structure the international financial system to its immense benefit.  The scheme that was developed, called the Bretton Woods system, had the United States dollar as the the primary currency with respect to which the exchange rate of the other countries were fixed.  The dollar itself was pegged to the gold standard and in return for this agreement the US promised to exchange dollars held by any nation  within the system to an equivalent amount of gold. To coordinate and maintain this global economic system, the International Monetary Fund (IMF) was established which was stated to provide assistance to distressed nations in the form of debt relief or to offset balance of payment and provide counsel wherever required. Every country had a quota in the IMF and with the United States having more than one-third of the total, it had to ability to veto any decision taken by the institution. In little or no real position to negotiate a better settlement, most countries accepted this proposal and although Britain was reluctant to let its position of pre-eminence slip away, the reality of its financial dependence on Washington for several decades into the postwar period made it acquiesce to the demands of the new imperial hegemon. Moreover, the sheer economic power of the United States was able to override any voice of concern that might have been raised amongst the 40 odd nations gathered there. That pact guaranteed American economic hegemony throughout the world. The dollar, which, at this point, was the only currency still convertible to gold, was stipulated to be the global currency; it was the most "liquid" asset with the highest demand, and consequently, the safest bet.  As part of the agreement all the nations were expected to open up their markets for trade which gave the US the full coverage of regions that had previously adopted a more protectionist stand. However, capital controls were not only allowed but were recommended. 

Consolidation and Stability (1945-1972)

In the few years following the Bretton Woods agreement, with Europe devastated by the war and its foreign reserves exhausted, it became an unfavorable situation where the US had plenty of surplus and instead of the dollars entering the international arena (as was desired under the system), it stayed at home predominantly. While the reason why Washington benefits from having the dollar as the global currency today is because it allows deficit-spending, in late 1940s when nearly half of the world's production was within its borders, it was the reverse: the US wanted to get rid of the surplus. This  Atlantic divide was known as the "dollar gap" and in order to reverse this trend, and also to improve Europe's industry and welfare and prevent it from succumbing to anything that scented of left-wing sympathy,   the Marshall Plan was proposed under which Washington would assist European countries with several billion dollars in aid.  In the next few years, partly because of the Marshall Plan, partly due the reversal of the policy to dismantle the German industrial capacity(again, delusions of Soviet influence), and partly because of many other internal factors, Western Europe recovered, its industries restored, its economy revitalized and its currencies strengthened. By the middle of 1955, dollars were copiously flowing out of the United States, and European exports (particularly German) were doing very well.  In fact, much to the consternation of American financial leaders, an independent Euro-dollar market was established which basically traded the dollars and dollar-denominated assets outside of American regulatory authority. This was a period marked by tremendous prosperity in the West with low inflation, low unemployment, increased economic stability and high standards of living. However,by 1959, the opposite problem was becoming the main concern, with lot more dollars circulating outside the US than what America could support with whatever gold reserves it held.  The situation became increasingly untenable and culminated in 1972, when President Nixon announced that the US would no longer back the dollar with gold. That marked the collapse of the original monetary arrangement and from that time onwards, the only "backing" for the dollar was the trust of the United States government and the size and stability of its economy. This ushered in an era of fiat currency and floating exchange rates which led to greater instability and fluctuations. Nonetheless, the dollar still remained, by inertia alone, as the global reserve currency and its demand strong as ever.

Global Economic Order 1972-

When a particular currency has established itself as the primary exchange for international trade, commodity pricing and adjusting exchange rates, it becomes imperative for every nation to maintain a sufficient reserve of that currency. Why would that be so? Imagine a situation where a small country is struck by a famine and needs to import food for its starving population. The reserve currency is required to make such purchases without jeopardizing the domestic economy. Likewise if a nation's currency  is falling, the standard move is for the central bank to sell the reserve currency and purchase the domestic currency thereby increasing demand for the latter. Conversely, if the value of the domestic currency is appreciating, the central bank would have to sell the domestic currency and the reserve currency is typically purchased in return.  Settling debt with the reserve currency would prevent any unforeseeable negative consequences to the domestic economy. Such concerns underlie the desire to hoard reserve currency even by the poorest of nations despite the fact that the interest rates are so low.  The natural question one may ask is why the euro or the yen is unable to take up that role. This is because although a significant amount of reserves are held in euros, the dollar still dominates the international markets and most commodities(especially oil) are priced in dollars and most currencies are pegged to the dollar. My answer sounds like question-begging but the real point to note here is that once something acquires the market share in the world that the dollar has done it is very difficult to displace it from that position.  Also, EU has never been very happy with letting the euro reach the hands of investors far from the eurozone (this was true ever before Irish, Portuguese, Spanish and Greek problems brewed). The Bretton Woods system was so formulated with this intent precisely in mind- securing the global hegemonic role of the dollar and thereby the United States.  With the US running deficits for the last 15 years or so, cheap credit has always been the order of the day because foreign governments are more than willing to buy Treasury paper. Even with the debt growing stupendously, having to fund imperial wars of aggression and invasion and making up for the refusal of both the corporate parties  to tax the rich, countries are willing to lend money for next to nothing. This situation clearly exposes the unfairness and ridiculousness of the global reserve system. Even on the face of it, it should be odd that that a single country's domestic currency  also functions as the global currency. Having rigged it this way, such problems are of course, inevitable.

Much like the Euro-dollar market in the 1960s, this form of economic dominance can unexpectedly be a double-edged sword for Washington. The case in point here is China. The latter holds more than a trillion dollars in US debt, and unlike several other nations, it is not for any specific emergency. The primary motivation for buying up the dollars is to prevent the yuan from appreciating. That way China can ensure its exports remains competitive and under free market trade agreements, the US domestic market is flooded with Chinese goods (a case of defeating you at your own game). With this mutually dependent(and simultaneously unfair)relationship between the superpowers at the background, the accusations that they level at each other is a complete farce. Despite all the bickering about Chinese manipulating currency, the last thing America wants is for China to call in its debt, which will surely shake the very foundations of the global economic order. Likewise,China will not stop buying US debt because the the US is the greatest consumer for its products. During the start of financial crisis in 2008, the decrease in exports led to unemployment problems for China and the last thing Beijing wants is a restive population demanding for political reforms and freedoms.  Hence the stalemate and the status quo and the downgrade is going to do nothing to change it, just as the Beijing and Washington annually sending critical reports of human rights condition to each other does little to change the multitude of abuses in either.

Where does the world go from here? Nobody really knows. Any reasonable analysis of the prevailing situation taking into account how such entrenched global standards -like eating meat and abusing animals, to quote another example - refuse to go away despite uncovering all the irrationality and destruction associated with it. It is of course, incredibly surprising how little all this gets mentioned in the media. The amount of loss accrued from accumulating Treasury papers more than outweighs any benefits from the US aid including those that come with the political conditions duly attached. The ethnocentricism and conservatism of mainstream American media prevents any honest discussion and debate on this topic.  Much like  other crucial issues, the problem is never fully addressed and instead what the public hears is a completely narrow and limited perspective of it.

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