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The credit dilemma in the united states

Pardee and Helen N. Legions of pundits have argued that the dollar's status as an international currency has been damaged by the great credit crisis of 2007-9 -- and not a few have argued that the injury may prove fatal.

The crisis certainly has not made the United States more attractive as a supplier of high-quality financial assets.

It would be no surprise if the dysfunctionality of U. A process of financial deglobalization has already begun, and it will mean less foreign financing for the United States' budget and balance-of-payments deficits. Together, these trends in supply and demand are a recipe for a significantly weaker dollar. And as central banks suffer capital losses on their outstanding dollar reserves, they will start considering alternatives. This is especially likely because these trends are superimposed on an ongoing shift toward a more multipolar world.

The growing importance of emerging markets has sharply reduced the United States' economic dominance, weakening the logic for why the dollar should constitute the largest part of central-bank reserves and be used to settle trade and financial transactions.

As emerging markets grow, they naturally accumulate foreign reserves as a form of self-insurance. Central banks need the funds to intervene in the foreign exchange market so that they can prevent shocks to trade and financial flows from causing uncomfortable currency fluctuations. This capacity becomes more important as previously closed economies open up and when international markets are volatile, as has been the case recently.

It is only logical, in other words, for emerging markets to accumulate reserves.

  • These show that foreign authorities have continued to accumulate dollars, and even accelerated their purchases in the first half of 2009;
  • In other words, China must move to full capital account convertibility; this is a prerequisite to the renminbi's coming of age internationally;
  • As a subsidiary reserve currency?
  • He wanted to signal China's unhappiness with prevailing arrangements and remind other countries, on the eve the G-20 economic summit in London, that China expected to actively participate in discussions of international monetary reform and to advocate a rules-based multilateral system;
  • Federal Reserve provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008.

But in what form? There is a growing feeling among economists and government officials that any system that uses a national currency, such as the dollar, as international reserves is seriously flawed. In order to acquire dollar reserves, countries must run current account surpluses with the United States. Insofar as foreign central banks are net buyers of U. This allows the U. And as has been shown at considerable cost recently, excessively low interest rates and easy credit are conducive to asset bubbles and, ultimately, financial instability.

These problems were not so pronounced while the U. But over the last decade, neither condition has prevailed. The flow of foreign finance for the U. To be sure, this was not the only factor to set the stage for the crisis; at least as important were distorted incentives created by skewed compensation practices for institutional investors and lax government supervision and regulation.

But to the extent that global imbalances did play a part in the crisis, the dollar-based reserve system is implicated. Like its economic logic, the political logic for a dollar-based international monetary and financial system also seems less compelling today.

  • They cannot use them to intervene in foreign exchange markets or in other transactions with market participants;
  • This would free China of the need to hold foreign currencies to smooth its balance of payments, and it would allow it to print more or less of its currency as needed, just as the United States does now;
  • The flow of foreign finance for the U;
  • But the euro area's stock of government debt securities is heterogeneous, with the bonds of different governments offering different risks, different returns, and different degrees of liquidity;
  • To be sure, the Chinese government would like to see the United States offer an exchange-rate guarantee on its dollar-denominated securities.

Today, it is not obvious to them why they should subsidize the U. In the foreign exchange market, the dollar actually strengthened following the outbreak of the crisis. When investors fled to safety, they fled to U. In the face of spreading illiquidity, U. Since then, the dollar exchange rate has fluctuated, but there has been no dollar crash. And there is no evidence of a massive loss of confidence.

The same conclusion follows from data on the composition of the foreign currency reserves of central banks and governments. According to the International Monetary Fund IMF64 percent of all identified official foreign exchange holdings were in dollars at the end of 2007, down only marginally from 66 percent in 2002-3 and still considerably higher than during the first half of the 1990s.

  • Insofar as foreign central banks are net buyers of U;
  • John Maynard Keynes' famous remark comes to mind:

The dollar represented 71 percent of all identified holdings in 1999, but this unusually high number reflected the one-time destruction of Germany's French franc reserves and France's deutsche mark reserves; these became domestic-currency-denominated claims when the euro was created.

IMF data on the composition of international reserves are incomplete, since some countries, notably China, do not report theirs. One way of inferring those countries' dollar reserves is to look the credit dilemma in the united states the U.

Federal Reserve's custodial holdings of U. Treasuries on behalf of foreign central banks. These show that foreign authorities have continued to accumulate dollars, and even accelerated their purchases in the first half of 2009.

All that has changed is that foreign central banks are now accumulating U. Treasury obligations rather than the securities of government agencies such as Fannie Mae and Freddie Mac and that they are favoring short-term bills over long-term bonds.

Late last year, the further accumulation of Treasuries arguably could have signaled that foreign public investors were shifting from bank deposits to Treasuries because they were alarmed by the condition of the U. But this is a less likely explanation today, now that confidence in the U. The crisis may have deterred private foreign investors from investing in the United States, but it has not deterred foreign central the credit dilemma in the united states, which are accumulating dollars at least as fast as before.

They are providing a growing share of the financing for the United States' current account deficit. At the most basic level, the economic logic for holding reserves in dollars, although less overwhelming than in the past, remains compelling. It still makes sense for countries to hold their reserves in the same currency that they use to denominate their foreign debt and conduct their foreign trade, since central banks use the funds to smooth debt and trade flows and intervene in foreign exchange markets.

And many countries continue to borrow and settle their trade in dollars, the rise of the euro and other potential competitors notwithstanding. At the end of 2008, some 45 percent of international debt securities were denominated in dollars, compared to only 32 percent in euros.

And according to the 2007 triennial survey of the Bank for International Settlements, the dollar was used in 86 percent of all foreign exchange transactions, compared to just 38 percent in which the euro was used the total for all currencies is 200 percent since two currencies are involved in each transaction. As of April 2008, according to the IMF, 66 countries used the dollar as their exchange-rate anchor, compared with just 27 that used the euro.

What peg a central bank chooses has an important influence on the currency composition of its reserves. Central banks want not just to maximize the returns on their portfolios but also to minimize their riskiness.

In a state that pegs its currency to the dollar, for instance, domestic inflation tends to track U. Estimates of what mix of currencies maximizes a particular combination of risk and return typically assume that all currencies are equally easy to buy and sell -- that is, they posit that all markets in bonds are equally liquid, no matter what currency they are denominated in.

This liquidity is critical. If reserves are not readily convertible into cash, they cannot easily be deployed in market operations -- hence the appeal of the market for U.

This liquidity is partly a function of the U. Foreign investors undertake their transactions and concentrate their holdings in U. Other currencies struggle to compete. The pound sterling and the Swiss franc were once important reserve currencies, but the British and Swiss economies are too small today for the pound or the franc to serve as more than a subsidiary reserve currency; neither country can provide debt instruments on the scale required by the global financial system.

The credit dilemma in the united states

Thus, at the end of 2007, the pound accounted for less than three percent of identified global reserves, and the Swiss franc accounted for less than one percent. Japan's economy is bigger, but the Japanese government long discouraged the use of the yen internationally on the grounds that this would undermine its ability to maintain a low and competitive exchange rate and complicate its conduct of industrial policy.

If foreigners had been able to buy and sell Japanese securities in large numbers, the Japanese government would have had more difficulty using the financial system to channel funds toward the domestic firms it favored. Japan now seems anxious to see the yen play a larger international role, especially within Asia, but its past policy has limited the market's current liquidity.

More recently, Japan's economic stagnation and zero interest rates have made holding reserves in yen unattractive. As of the end of 2007, the yen accounted for barely three percent of total identified official holdings of foreign exchange.

Japan's aging population will mean that its economy, as well as its currency, is unlikely to play an expanding global role. THE EURO STAR This leaves the euro as the only reasonably serious rival -- not exactly a coincidence given that one motivation for introducing the euro in the first place was to create a European alternative to the dollar.

The euro area, which comprises the 16 members of the European Union that have adopted the euro as their currency, possesses the requisite scale: But the euro area's stock of government debt securities is heterogeneous, with the bonds of different governments offering different risks, different returns, and different degrees of liquidity. German government bonds have a reputation for stability, but since institutional investors tend to hold them to maturity, the market for them lacks liquidity.

Other euro-area countries have serious financial problems. Ireland's sovereign debt has been downgraded by the rating agencies, and there are worries that ratings for the bonds of other euro countries, such as Greece, Italy, Portugal, and Spain, could drop, too. Italy has the largest outstanding stock of bonds of any euro-area country, but its economic troubles make them unattractive as reserve assets.

The current global economic crisis has encouraged talk of issuing euro-area bonds with the backing of the entire set of euro-area members, including, most importantly, Germany. If this were done on a significant scale and if this debt were to replace the member states' national debt securities, the euro area would possess a market with roughly the uniformity and liquidity the credit dilemma in the united states the United States' Treasury market.

But such radical fiscal federalism is not something to which the German government, among others, is likely to agree. Financial markets in the euro area will undoubtedly expand as more EU members adopt the currency. If nothing else, the economic crisis has strengthened the euro's prospects as an international currency by driving home the fact that the euro area can be a safe harbor in a financial storm.

The European Central Bank has more capacity to act as a lender of last resort than, say, the National Bank of Denmark. And intra-European solidarity notwithstanding, the only way a state can guarantee its access to exceptional liquidity from the ECB is by adopting the euro. Markets in euro-denominated securities may not have all the liquidity that might be hoped for, but they are at least more liquid than the market in Danish krone. This became clear in the turbulence that followed the collapse of Lehman Brothers in the fall of 2008.

Whereas the ECB was able to cut interest rates and flood distressed financial markets with liquidity, the The credit dilemma in the united states Bank of Denmark had to raise interest rates to defend the krone, which had fallen as a result of deleveraging by foreign investors.

Now, opinion polls in Scandinavia and policy statements by eastern European officials indicate greater support for adopting the euro. Not so in the United Kingdom, ever the outlier on these matters.

The Dollar Dilemma

There the crisis has tarnished the reputation of the pro-EU Labour government and strengthened the euro-skeptical opposition. But this is not going to happen anytime soon. Meanwhile, EU members oppose accelerating the admission of new eastern European countries to the euro area. The implications are that the euro area will expand slowly rather than rapidly and that the euro's rise as a rival to the dollar will be gradual.

The euro's importance as a reserve currency will grow first and foremost on the euro area's own periphery. It is already the dominant currency for trade among EU countries outside the euro area. The EU is also seeking to develop stronger ties with the non-EU countries to its south and east.

The EU relies on its neighbor Russia for its energy supplies, and Russia, in turn, relies heavily on the EU for revenues. As countries in the EU's neighborhood develop deeper links with the union, it will make sense for them to hold more of their reserves in euros.

For example, in recognition of the growing importance of Europe for its trade and finance, Russia has recently raised the weight of the euro in the basket of currencies it uses to guide its exchange-rate policy.

It follows that the country will also want to hold a larger share of its reserves in euro-denominated securities. Russia's central bank confirmed in its most recent annual report that it had increased the share of euros in its reserves from around 42 percent to more than 47 percent between the beginning of 2008 and the beginning of 2009 while reducing the share of dollars from 47 percent to under 42 percent.