Yes, groan. None-the-less, thanks for the link. It was very interesting to hear this interview with William Clark, who seems to be the master source of the Iran Oil Bore myth.
No one will be surprised to hear that I do not agree with his assertions here or elsewhere. Broadly he combines speculation with some basic economic misunderstandings that create story that sounds plausible. Note: my comments refer only to the IOB and dollar pricing of oil. These are not comments on the ongoing strength of the dollar or US economy, war with Iran, war with Iraq, US foreign policy, etc. I see these as entirely separate issues and mixing them only confuses things and gets people upset.
Clark purports that the Iran Oil Bourse, and more broadly trading oil in dollars, is the main threat to dollar hegemony. As documented clearly here and elsewhere the primary strength of the dollar lies in the long term holding of dollar assets, which countries do voluntarily - not by its use in transactions. In any mainstream economic discussion this point is not disputed.
As I have said before, a country that does not want to hold dollars can buy them moments before they make the transaction. This does involve holding some foreign exchange, but it can be Euros.
Clark also holds a few major misunderstandings of macroeconomics. Fundamentally, he seems to not understand what a price is and can't clearly explain how countries would actually switch to the Euro. More importantly, the majority of what he fears will happen actually already does.
First, oil can only be priced in one currency, although this price can reflect the value of the basket of currencies that it is traded in. Oil could be quoted in any currency you want, but this would only be a translation of the dollar price. Obviously of the price is different in different currencies, buyers will just trade in the cheapest currency.
Currently oil's price reflects its underlying value based on supply and demand. If that price were stated in dollars and translated into Euros or the other way around, the numbers would be the same. If Chinese demand causes the oil price to go up 10% and everything else stays the same, everyone bears the same price impact. The US, Europe and China all pay 10% more for oil.
Secondly, it is not true that the US faces no currency risk (and others do) because of the dollar price. As Econbrowser (see link below) noted, the price of oil already follows the basket of currencies in which it is traded in. It does not correlate to the dollar.
Clark claims that the Iraqi economy boomed and the Euro value jumped once that country switched currencies. If this is the case, one must assume that Euro countries and Russia are voluntarily accepting a massive tax on their economies to subsidize the US. Still the only reference Clark could cite from Russia was a response to a question put to Putin in 2003. I think it is odd that if this issue were really this important, it would not be met by such silence on behalf of two potential beneficiaries.
All of this gets no coverage by the MSM or mainstream economists (or Russia, or China, or the EU) not because there is any plot, but because they do not take it seriously. There are dozens (if not hundreds) of economists saying that the US economy is heading for recession and that the dollar will crash. But it is a small fringe group that claims the IOB has anything to do with it.
Luckily, this debate does not have to drone on endlessly. The question will be answered in one short month. Let's wait and see. My guess is that Iran will postpone again, because they like having a threat more than running an exchange that may or may not work, but won't trade non-Iranian oil and won't make any difference to anyone.
Here are two very good links. We have also had great discussions on this at TOD in the past.
I also have the same doubts, but they have nothing to do with the economics voodoo magic presented by Jack. And everything to do with US isolating and destabilizing Iran, so that nobody dares to participate in IOB.
What economics voodoo magic did I present? I want to know so that I can do it again.
Clearly the US pressure on Iran is destabilizing and would make participating in the IOB more difficult. But this is not the only factor giving Iran massive credit risk. The IOB is a nonstarter as an international trading platform in any case. I think it is inaccurate to claim that the only - or main - reason why Saudi Arabia (for example) would not trade on the IOB is US pressure.
I think that the arguments against what you said have been repeated way too much but I'll do it again because I never saw these addressed anywhere.
In theory what is the currency of the transaction may not matter. But in practice it does matter big time. First the exchange rate risk is priced very expensively by the market as evidenced by the huge foreign currency reserves the central banks hold.
There are also the transaction costs and the risks associated with them (they are also widely fluctuating).
Third, and most important actually is that the only reason to prefer one currency against another is confidence in it. In a fiat currency world confidence is based only on the perception that the currency of choice will be valuable and demanded in the future. If you don't have that confidence you will simply pick another one.
I call your claims "voodoo economics" because these are the type of assertions economists use to induce self-fullfilling wishful thinking in the markets. The funny thing about economics is that virtually any theory or prediction may become or be true within a certain timeframe if you wish and believe in it. If you wish something you start believing in it, if you believe in it, then you make the corresspondent investment decisions. If the majority of market players make the same investment decisions your wish is coming true!
You said: "If you wish something you start believing in it, if you believe in it"
I think this at the heart of the IOB issue. People wish the dollar would weaken, know that there are reasons why it should, then assume that the IOB is the answer. I have agreed that there are risks facing the dollars and that it should weaken. But this doesn't make me beleive that the bourse is kryptonite.
You didn't say "Voodoo Economics" you said "Economics Voodoo Magic" which I liked a lot better. Voodoo economics usually refers to Reagan's supply side theories, which have absolutely nothing to do with what I have said. Calling any of it "Wishful thinking" is a case of seeing what you want to see. I have not said a single positive thing about the dollar and there is nothing in my claim that says it won't go up in smoke. I am happy to accept for the sake of the arguement that the dollar could crash and no longer be the global currency. What the IOB has to do with this is unclear.
I am trying to have a analysis-based discussion on the IOB and the fact that everyone wants to insult me and change the subject certainly hasn't made me doubt that I am right.
Your third point above is the most significant. But again the important issue is holding US dollar assets long-term, which is still being done. Nothing that you have said provides any evidence that the US of the dollar as a measuring stick underpins the empire.
People wish the dollar would weaken, know that there are reasons why it should, then assume that the IOB is the answer.
Personally I don't want anything like that. I'm simply trying to reject the opposite type of wishful thinking that has supported our bubbling economy through the years and is driving the risks to the skies. My opinion is that we should try to attempt soft landing before it is too late.
I am trying to have a analysis-based discussion on the IOB and the fact that everyone wants to insult me and change the subject certainly hasn't made me doubt that I am right.
I don't see an insult here, neither change of the subject. Pumping up an economy without exports and a disappearing industrial base like there is no tomorrow has lots to do with wishful thinking and little to do with economic fundamentals.
But again the important issue is holding US dollar assets long-term, which is still being done.
And so what? If things start unwinding whether you hold a one year or 30-year asset is all the same - you still have a hot potato you will try to pass on to the next dummy.
I think you missed the main point of number 3). The value of the dollar is based on perceptions. IOB might take a minor share of the dollar trade. But the risks that it would change the perceptions of the major players are enormous. The scenarious that can develop vary but the least that can happen is that FED will be forced to raise more aggressively interest rates to pay for the rising risk premium the dollar will be charged with. We may need to pay with a forced recession, and with debt levels to unprecedented heights this could get very ugly.
I think I will not exaggerate if I say that if significant portion of the world trade switches to euro this would mean the end of the independant monetary policy of US. For all practical purposes this would be equivelent to the end of the US empire.
When someone uses the economic term "soft landing" it means to me that he prefers high unemployment over inflation. The term only comes out of the mouths of people who isolated from the risk of unemployment.
Sorry, but you are entirely mistaken about the term "soft landing" and its meaning. "Soft landing" refers to a reduction in the rate of real economic growth, as opposed to a recession, which by definition requires a decline (as opposed to a reduction in rate of positive growth) in real Gross Domestic Product.
You are correct that unemployment increases any time growth in real GDP declines below about 3.5% for any substantial length of time. The main justification for economic growth is that it is necessary to keep the rate of unemployment down.
The problems of coming to grips with a steady state economy have not been worked out even in theory, much less in practice.
Actually quite the opposite, my branch is predicated on growth and discretionary spending so I think I would be pretty much on the list. But I've been through hyperinflation once... it ain't fun either. And you still can lose your job, or even worse - the paycheck you get will not be worthed the paper.
On the other hand, bearing in mind the overexposed external position of the US economy, I can't see some mild scenario of 10% inflation and moderate unemployment... it will probably be either or. My best case scenario would be a moderate recession and a gradual reduction of the debt in the next decade or two.
I should not not have said that "everyone" wants to insult me or made it appears as if you did. I retract that sentence.
I do think you are changing, or at least avoiding, the subject. I have acknowledged every economic point that you make in your post, except the last one.
I do not accept the point that there is much causality between the currency that countries trade in and the currency that they hold assets in. I suspect the most likely case is that the world continues to trade in dollars, but that there is a reversal of the desire to hold dollar assets. So my scenario is as pessimistic as yours. I'm just not buying into the party line that dollar trade underpins US strength and that the IOB is the weak link.
I see the IOB myth as a Star Wars fantasy. People want to believe that the US is the Deathstar, but that it has a fatal flaw that can easily bring it all down. I don't see it this way.
My point was that I keep saying that the dollar and US economy may have serious problems, but that the IOB is not one of them. The most common reply is to attack the first half of the sentence, where I have already agreed with you.
If you were to separate out all of the rebuttals to my IOB arguments that really refer to the IOB (not rebutting things I have accepted) I think you would find that they are brief, petty and unsubstantiated.
Your claim of battling wishful thinking is again attacking a windmill that doesn't belong to me.
I think what we do not agree upon comes down to here:
I do not accept the point that there is much causality between the currency that countries trade in and the currency that they hold assets in.
This is a very disputable point at the least. I would compare it to the idea that there is no connection between voltage and the electrical current. Yeap, there are other factors like resistance, self-induction etc. but trade is the reason why foreign funds get accumulated at the first place and a claim that there is "not much causality" is... let's say strange. If we assume that there is no causality then we will need to explain why the funds held internationally in New Zealand, Canadian or Australian dollars for example are such miniscule amount compared to US dollars or Euro. The connection between trade and funds for different economic agents varies, but I would rank it this way:
Central banks prefer to hold foreign currencies which are demanded domestically, especially for imports. Especially for strategic imports like energy.
Importers need the currency of import and usually hold foreign currency accounts to hedge against currency risk.
Commercial banks prefer to hold foreign funds liquid within the country their operate in - that is if a country does not trade with Australia a commercial bank will have less reasons to hold Australian dollars.
Hedge funds, individuals and other "secondary" players may have more speculative reasons and invest in less demanded currencies (because of higher interest rates etc.) but in such cases they have to pay a much larger margin.
I'm sorry but I think your point is a little bit "US-centric". If you live in US you get the feeling that international money markets are like groceries - you go in and just buy the funds you need. The reality is that if your currency is demanded internationally it is almost like that, if it is not you need to use another currency as a medium which is equivelent to forcefully credit the country that emitted it. Very convenient isn't it?
First, I live about 13,000 kilometers from the nearest major US city and don't get paid in dollars, so your US-centric remark is spurious and has little use except distraction from the real point.
You are right about the area of our disagreement, but none of your follow up points do much to advance your view. Of course countries need to hold foreign exchange if they want to trade. But is doesn't have to be dollars unless they trade with the US. Even so, they can convert at the time of purchase. International currency markets are the largest, most efficient, and most liquid market in the world.
Again, the real issue is the currency in which long-term assets are held. Why does China hold 70% of their reserves in US dollars? You seem to think it is because they have received them and find it too difficult to convert other currencies. This is wrong. I don't think anyone really believes that the currency balance held by banks in Korea, China, Japan, etc. is determined by what they receive in trade.
These countries have a strategic plan for their currency holdings based on return and exchange rate management. It makes no difference what currencies they receive through trade. They will convert and adjust to meet this strategy.
You say `trade is the reason why foreign funds get accumulated at the first place and a claim that there is "not much causality" is... let's say strange." This is also wrong. It is analogous to saying that you receive your income in one dollar bills so you keep your savings in one dollar bills. My claim above that countries determine the balance of their currency holdings based on return and exchange rate considerations is the undisputed mainstream view. The reason that countries such as China do not hold large amounts of New Zealand dollars in because that currency is regarded as riskier in capital markets, lacks the depth of the dollar and is not liquid. Just because you don't the like the fact doesn't make it untrue.
I think you have a fixation on US-centric, wishful thinkers, which is distorting your perceptions. If you leave that out of future posts they may make more sense.
The reason that countries such as China do not hold large amounts of New Zealand dollars in because that currency is regarded as riskier in capital markets, lacks the depth of the dollar and is not liquid.
And why is it not "liquid"? And why is it "risky"? Are New Zealand or Canada dangerous places to make business with? What can China buy with New Zealand dollars? Sheep?
I think at another place I pointed out that 60% of all international trade is being done in dollars. Countries trade in dollars that's why they prefer to keep dollars to buy what they want at any time without paying for the risks and the transaction costs. The less a currency is traded with, the more it is "risky" and the less "liquid" it is which is the another way of sayng that transaction costs are higher.
What you keep staring at is the secondary market where agents redistribute their foreign currency portfolio between themselves but the primary reason for them to have a portfolio at the first place was just one: trade. Money without anything you can buy it with is plain paper.
Sorry I don't have what else to say except that "international trade is the underlying reason for accumulation of foreign funds" was stolen from my books of International Finance. I'd like to see what yours say.
LevinK: I think what we do not agree upon comes down to (Jack's claim) here: "I do not accept the point that there is much causality between the currency that countries trade in and the currency that they hold assets in."
However, I think that our disagreement is part substantive and part semantic. So here is an attempt to clarify my meaning and some terminology:
Foreign Exchange Reserves (FER) are a subset of the total assets that a country holds in foreign currency denominations.
FERs (see definitions below) are short term liquid assets that are used to finance net payments to foreigners and intervene in currency markets.
Countries need to draw down FERs only when they have to make a net payment to foreigners (Eun/Resnick - see below).
Countries also hold long-term assets, which are equally important. A dollar is a dollar, regardless of what class it is held in.
The holding of US dollars assets by the largest holders (China, Japan, Korea) are greater than their need to make trade related payments by a huge amount. Actually, most if not all of these countries have balance of payment surpluses and no requirement to make net payments to foreigners.
Only a tiny portion of the assets held by these countries can be explained by the need to make trade payments.
A complete removal of US dollar pricing of commodities, including oil, could lead to the value of dollar based foreign exchange reserves that are held shrinking to something more in line with the value that each country trades with the US. However, this is a process that has been ongoing. The dollar as a portion of FER has shrunk from 68.6% in 1980 to 57.1% in 1997.
It is the currency that countries hold over the long-term that makes a difference, not what is used in trade. As I said above:
"Again, the real issue is the currency in which long-term assets are held. Why does China hold 70% of their reserves in US dollars? You seem to think it is because they have received them and find it too difficult to convert other currencies. This is wrong. I don't think anyone really believes that the currency balance held by banks in Korea, China, Japan, etc. is determined by what they receive in trade.
These countries have a strategic plan for their currency holdings based on return and exchange rate management. It makes no difference what currencies they receive through trade. They will convert and adjust to meet this strategy."
"you don't need to acquire any U.S. assets in order to purchase a barrel of oil that is priced in dollars."
"the key question in my mind is what asset do the oil producers want to be holding immediately after they've sold the oil? If what they want to hold is U.S. Treasury securities, then I agree with you, the transaction has led to an increase in the demand for dollar-denominated assets. However, if that is their desire, I see no reason why they wouldn't do exactly the same thing if the sale were transacted in euros, namely, use the euro proceeds to purchase dollars for the Treasuries. Nor, if what they ultimately want is euro-denominated assets, does anything prevent them under the current system from immediately converting the dollars into euros. This is why I suggest that it is the final demand for assets rather than the unit of account of the transaction that is of primary importance."
"I will grant you that somebody must hold some extra dollar-denominated assets during the time it takes to complete the transaction itself. However, I expect that the contribution this makes to the demand for U.S. base money (the sum of physical dollar bills plus Federal Reserve deposits) is unlikely to be very large, and certainly not something that could cause the end of an empire, as if the total seignorage the U.S. collects from all sources were all that huge in the first place. "
9. According to The Federal; Reserve Bank of San Francisco (http://www.frbsf.org/publications/economics/letter/2003/el2003-11.html), "Since the 1997-1998 Asian financial crises, monetary authorities in emerging markets in East Asia have more than doubled their stockpiles of foreign exchange reserves; by the end of May 2002, they held $845 billion, or 38% of the world total. Of these countries, China, Taiwan, Hong Kong, South Korea, and Singapore rank just behind Japan as the world's biggest holders of foreign exchange reserves--together those five countries hold reserves totaling nearly $700 billion." How do you see this doubling as linked to trade?
My Int'l Finance Textbook agrees with yours and states that "the dominance of the US dollar (as a FER) may be attributable to the fact that roughly half of world trade is invoiced in dollars. Most commodities are priced in dollars". I do have to acknowledge that international trade and dollar pricing does play a role in accumulation of the portion of short-term reserves that is attributed to making net payments to foreigners.
But my claim is that this is a small portion US dollar assets held by foreign countries. If this dollar dominance were to be eroded, the impact on the US would be somewhat negative. It is conceivable that the IOB could be a small factor in this happening. I have never disputed this.
My contention has always been that the threat from the IOB is microscopic in comparison to two other threats to the US economy and role of the dollar, both real:
1) Iranian Oil resources
2) Waning interest in holding long-term dollar denominated assets by foreign countries.
Given that there are real issues, I wonder at the amount of efforts committed to pumping up the IOB, which I see as a diversion at best. I maintain my position that the IOB scare is a conspiracy theory on steroids.
Purpose
Reserves can be used by the country's central bank to purchase the country's currency in an intervention. This allows it to control the exchange rate; increasing demand for the country's currency increases its value as compared to the currencies of other nations. Countries often have reserves because they fear speculation and economic shocks might affect their exchange rates, and they want to be able to keep their rates steady. http://en.wikipedia.org/wiki/Foreign_exchange_reserves
TEXTBOOK:
International Financial Management
Eun/Resnick
McGraw Hill
OK, I do agree that there are other reasons for accumulation of foreign funds:
Exchange rate management in the case of central banks
Receiving a higher yield
Expectations for speculative gains
The core of my argument is that in the medium to the long run all of them are dependent on the demand for dollars for transaction purposes:
1) The central bank reserves are overwhelmingly accumulated by purchases from the domestic market. If country agents do not use dollars for trade, the banks will accumulate euros or whatever they use. If it stubbornly converts those euros to dollars it will have to continuosly go to the international market every time its residents sell or buy their euros.
China and Japan have USA as their most important trade partner, and the impact on their official reserves is evident.
2) Higher yelds attract investors but if a currency is considered risky the yield premium must be higher. Example: current USD/EUR IR differential is above 2% but the dollar has not appreciated significantly. The reason is that there is a risk premium payed by US government because the dollar is already considered risky.
How risky is a given currency is directly related with demand for it as a transaction currency. New Zealand dollars are not demanded by agents because you can not buy lots of things with them. A currency that is not used in the international trade is prone to huge fluctuations - if you buy lots of NZ dollars it will appreciate and then probably depreciate with time. Investors need security and therefore invest in funds that will be liquid and demanded in future.
What is the term structure if your portfolio is absolutely irrlevant to this discussion. China's national bank does not have to wait 30 years to cash its US bonds if its residents need US currency. Or if they start demanding euro it does not need to wait 30 years to restructure its assets.
3) Speculative gains funds are short-lived and are directly related to funds 1) and 2). Speculators continuously monitor where the major players (central and commercial banks) direct their funds and rush to follow them and profit from the currency appreciation/depreciation.
I searched for statistics to compare the portion of foreign assets in dollars in 1980 and 1997, but could not find any. I would bet though that it has gradually declined along with the portion of dollar in foreign trade.
I would sum it up:
The impact of trade on foreign currency funds is very significant, but comes with a lag which may last years.
The impact of IOB may not be significant as a portion of trade but will adversely affect the perceptions of the traders, escpecially speculators. This effect is generally unpredictable and introduces the major risks in that game.
Market shows that agents pay for risks big time. I can deduce that USA is willing to pay for this risk even with war if needed.
Sorry for the long post, I hope I made my points clear.
Don't understand this, "Clark also holds a few major misunderstandings of macroeconomics. Fundamentally, he seems to not understand what a price is and can't clearly explain how countries would actually switch to the Euro. More importantly, the majority of what he fears will happen actually already does." And if the majority of what he fears (if you mean widespread transactions in oil in other currencies?) already does, then it will only be more pronounced and its effects will increase.
You say yourself the strength of the USD lies in countries VOLUNTARILY holding dollar assets. I note you did not say that it has value in itself. I hold no USD assets, because I do not want to accept the risk that it will devalue in realation to the EUR another 25%, therefore I effectively believe they are worth nothing! When the rest of the lemmings catch on, maybe you'll get the same signal.
Also as you say, the oil price follows the basket of currencies it is traded in, then why in hell should there be only an official USD price? As for why it continues at this point, same as the chicken and the egg. When it happens it will happen. Sometimes, just gravity and inertia holds things together. How long did we believe the world is flat, when so many people knew differently?
Did not Europe (most of) switch to the Euro, from many currencies? How is it impossible to switch. They'll do it just like I did it. Reduce my purchases made in USD and then all of a sudden, you don't need them anymore. Right now nothing much other than used F-14s, Boeing 767s, and US Treasury Bonds, Yahoo and Goodgle stocks and oil is sold in USD. I only buy oil here, and I can't buy that in USD either. You disregard what is not convenient to your logic.
Don't understand your statement, "First, oil can only be priced in one currency." That's like saying cars can't be priced in Euros. I bought a truck in Spain with money from my last USD account I had. I converted USD to Euros and paid in Euros the price they were asking in Euros. Obviously one can always take the daily exchange rate and make a conversion from any currency to any other currency. The simple advantage for Spain, or any country or business that trades with Europe and happens to have excess Euros in their account when they would like to buy oil, is that they would be able to use those Euros to buy oil if they chose to do so and thereby avoid a costly step in the ladder, making a conversion transaction from Euros to USD for NO reason other than to keep the bankers fat and happy. Say its only 1/2 pct for 1000 bbls and its 300 USD, but scaling up to 5 MMBOPD, its a cool 1.5 E6 USD in transaction fees alone. I simply ask WHY should they, he, she or I be forced to pay for oil in USD?
A completely localized market could develop for oil priced in any currency, same as cars, which due to inhospitibal logistics, does not make it convenient for international transactions. In the above example, would I convert from USD to Euros, buy the truck in Spain and drive it to the US, if I could buy the truck in Canada for USD and take it home to Detroit? NOT!
Another reason. You disregard future changes in value between the USD and the other currencies. Currency exchange risk, which is significant if you believe in the fundamentals of the USD. Given the poor fundamentals, most mainstream economists think there is a significant chance the USD can devalue at any given instant. In fact they now have to rely on "Dark Matter" to explain its otherwise inexplicable buoyancy. Just like the physicists, they have no idea what economic dark matter is, or how much exists. So, if I otherwise avoid USD, because I don't need them for anything other than to buy oil, and I just happen to think that the USD price appears to be low in relation to the Euro, and I buy USD today intending to use them 6 months from now for buying oil, and at the same time the USD devalues in relation to EUR and the EURUSD rises less than 50% in relation to the USD, then oil will cost me more Euros. If the price of oil was always in Euros, you would pay 2 times the USD and I would pay the same in Euros. What I'm trying to get across, is why should I have to accept a risk on whether I think the USD will increase in value or take a significant risk that it will decrease anytime I want to think about my oil purchasing schedule for the year?
Prices for anything tend to have their underlying value set in the currency most convenient for the parties doing the buying and selling, and others making the appropriate conversion, which up until now has been the US, but there is no reason to believe that you guys will be the major buyer in the future. Perhaps the price will be set in Euros, Yuan, or Yen and conversion will be made to get to USD equivalent prices. You've got no reason behind this statement that I, and I'm sure many others, cannot see.
Lastly, you say "Wait and see". Fine, I'm happy with that, but you could have said that first and dropped all the rest of the logic, as with that statement, you admit that you've got no more clue than I do what will happen. My only point is how long can the economists continue to believe in, "Dark Matter". In the meantime, I point to the 47% increase in the EURUSD since 2001, oil price in USD considered or not, and ask why should I be forced to convert EUR to US pesos even for 1 second just to buy oil?
I'm not sufficiently knowlegeable on economics to comment intelligently one way or the other on the economic impact of the Iranian Oil Bourse on the US.
However, it's axiomatic that in politics and international affairs perceptions are at least as important as reality. And in that regard, I suspect the rulers of the US are quite upset over the IOB, if for no other reason than that it exists at all and that it represents an extended middle finger in the face of the omnipotent US.
They are probably also worried about countries with a grudge against the US and the UK switching from New York and London to the IOB just out of spite. And it could set a precedent for countries avoiding the dollar in other types of transactions. So perhaps the IOB is just a secondary reason why the US has it in for Iran - its overt hostility towards Israel and its alleged nuclear weapons program being the primary ones.
Oil can only have one price, which is translated into whatever currency someone wants to buy it in. It seems obvious that there can not be a better deal in one currency rather than another or else everyone would just use the cheaper currency. This could be quoted in Euros and translated into dollars or the other way around. However, there is no magic here. Oil is worth what people will pay for it. The symbol in front of the price doesn't change this. Go ahead and change the price to Euros tomorrow. Who cares? It won't be any different.
If the dollar Euro exchange rate is one dollar to .8 Euros. What difference does it make if a unit of oil is priced at one dollar and translated into .8 Euros or priced at .8 Euros and translated to one dollar? It has to be in one currency for consistency. It could be Euros as well as dollars, but this is like claiming that using the metric system would bring down the empire. You can get over a wall just as easily whether you measure it in inches or millimeters.
Cars, oil, anything can be priced in Euros. But it wouldn't change anything. It is just a price. Likewise a race can be measured in miles but you would be foolish to say I can't run 16 kilometers, so I'll only go ten miles. The price is no different. Euros, dollars, miles, kilometers. None change the underlying reality. But you need to measure in one unit all the time.
You say that converting currency is an expensive step on the ladder that keeps bankers fat and happy. Look up the dollar-Euro spread some day. It is not expensive. And I claim that Euro is buying oil from Russia in Euros already. I don't believe they are converting to dollars. They only use the price as a measure to see how many Euros. I have made this claim before and it has not been refuted. If I am right it makes a mockery of the whole IOB claim.
When I say the majority of what he fears already happens, I refer to:
1) The US bearing currency risk: They already do as oil follows a basket of currencies and is not correlated to the dollar. The US bears the same risk as everyone else.
2) The idea that pricing oil in Euros requires the use of dollars is not really true. Countries can hold Euros, convert to dollars and buy oil. The seller can then convert to Euros if this is what they want to hold. If this was all done through one institution, the funds are in dollars for less than one second and in Euros for a long time. The claim that removing this one second of dollar use will bring the US down is absurd. As I said above, I do not believe that Europe buys oil from Russia in dollars. They follow a dollar pricing system, but what is stopping them from agreeing to use Euros? Nothing. The price is not a requirement of currency use. I am sure that European oil trade with Russia is effectively done in Euros right now.
You say the dollar will fall and is intrinsically worth nothing. Fine. No disagreement from me. But this has nothing to do with the IOB.
You wrap up by assuming that I am defending the US and the dollar although I explicitly said I was not. You can mix up these arguments all you want, but you are not making any point. I have admitted the dollar has weaknesses. I don't make any claim regarding what will happen to it. However, your long rant barely addressed the key point. The IOB won't change anything.
Correct. And not only correct, but obviously correct to anybody familiar with the economic history of the twentieth century and who also has a fairly advanced knowledge of real-world economics and finance.
Do you mean you can't "get it?" Well, that does not surprise me. However, in all seriousness, if you would like a list of ten excellent books to study (and after you study them, what is obvious to those who are informed would also be obvious to you), let me know, and I'll post the list.
Sorry, cannot do that. With the great pain I could cut the list from ten books to nine, but there is no shortcut to knowledge.
What puzzles me is the widespread belief by some people who post here that they can obtain solid knowledge easily, quickly and without effort. Sorry, the world does not work that way.
If you want an easy read with no graphs and no algebra but great prose and wit, get any edition of THE WORLDLY PHILOSOPHERS by Robert L. Heilbroner. From this book you'll pick up a lot of lovely tidbits you can use at cocktail parties, but more important you will get an appreciation for how economists think. Yes, good idea: Start with that book, and I'll recommend others from time to time.
[There is a]widespread belief by some people ... that they can obtain solid knowledge easily, quickly and without effort. Sorry, the world does not work that way.
Oh how true.
I see it in my work all the time.
Amazingly, it is these same people who send their partially-matured kids to college for 4 or more years --at great expense-- to learn that which they claim can be acquired with a few well-barked sound bites (e.g., what is thermodynamics?, what is physics?, what is economics?, etc.). Can't they see how foolish it is to send kids to school when it can all be internalized with a few minutes of effortless osmosis?
But then again, "common" sense is for the "common" among us.
Keep up the good fight :-)
Thank you. I put thirty-one years into fighting the good fight at a community college, in large part because of my belief in the American ideal that common people deserve an opportunity to improve their minds.
wow 31 years as a veteran of the good fight!
thank you.
our country owes you gratitude.
as one who has been lucky to have a few good teachers cross my path, I am always humble to remember that I am not a self-made person but instead a product of the dedicated efforts of all those great educators.
What I do understand is that when I'm starving and you're not, I'll pay a higher price for a McDonalds hamburger than you will. How much higher, depends on if I'm just hungry, or starving, or if I think I will die tomorrow even if I eat one. When I'm not starving I will not buy one at all. This I know to be true, so please quantify that equation in economic terms. And McDonalds (using the official FRB NYC 1pm exchange rate for last Friday) cost more here than they do in Minnesota, so there must be a different economy here for McDonnalds hamburgers than there is there, although supposedly people here do not even like McDonnalds as much as they do there. Now PLEASE explain that phenomenon, using WHICHEVER one of your economic books you choose and then please, why the same couldn't happen for oil.
Now, let me go back to working on how a bumblebee flys; much more useful.
In all seriousness, are you familiar with "The Big Mac" index in "The Economist" BTW, if you would like to know what is going on in the world and (at least to some extent) what it means, read "The Economist."
BTW, I know how a bumblebee flies. This "problem" was solved at least twenty-five years ago.
Don't inturrupt me. I'm reading the Economist right now, like I do every week. I'm still working on bumble bees. I find my solutions today more practical than how they solved things 25 or 50 years ago. CFD really couldn't be done so elegantly then. Could only look at a bunch of numbers in the tables, then later, only 2D cross sections. Now I can see 3D, or rather I could if both my eyes worked. I have more CPU on my watch today than the whole world had in 1961. And BTW, it was just recently proven how BB "do it". Before that it was just theory. Its only my blind eye don't work.-) But I now find CFD boring and I changed to working on distributed grid agent based computing for world economic modeling including all major economic powers, population, economic policy, GDP growth, energy consumption forecasts, EURUSD, USDJPY rates and oil prices, excluding local market perturbations. In all seriousness.... the preliminary results scare me.
I generally agree, except for a relatively small point of market psychology.
First, I see the demand for holding US $ and US assets being sated and "eventually" creating a glut. The Central Bank of China (previously 70% US $) has talked about "diversifying". As a major holder they have no incentive to talk down the US $.
When will the break occur, when will the desire to hold US $ vs. Euros, yen, won, Swiss Francs, Aussie, Canadian & NZ $, etc. change ?
When a panic sets up IMHO (and observing other currency runs). A panic is based upon market psychology.
There is an unconscious, and not very logical link between holding dollars vs. other currencies and getting what I want (oil for example) because it is priced in US $.
Does the illogical have more impact upon the less experienced (say Central Bank of China) vs. more experienced (say Bank of England) ? Don't know but expect so.
Logically, one cannot use dollars to get what one wants from the US directly because there is not that much one wants from the US (see Balance of Trade) and there are LOTS of US $ floating around and more every day ! The US $ is more useful for 3rd country transactions.
A sudden break in oil transactions from US $ to Euros may well be the catalyst for a break down in confidence. Or it may be something else ($100 oil for example, or problems with US mortgage market or ...).
A break down that will occur in any case "sooner or later" due to our huge Balance of Trade and Payments deficits.
Recently I've been thinking to make a correlation analisys between price of oil, gold and the dollar/euro exchange rate.
I'm making a preliminary bet for 60-70% correlation - when oil goes up, so is gold and the dollar tanks. With oil being the cause and the others - the effect. I think all the information we are talkng here is pretty much incorporated within the markets. Everyone is waiting it to happen, but fear (long-term thinking) has a long way to overcome greed (short-term thinking). They will try patching the situation with higher interest rates for a while, but if oil gets to 100$... clearly anything is possible.
That is exactly the point I was trying to make until I got lost in a rant. Apologies, where due. I think various local market conditions can spawn intricate local prices in USD, EUR, gold, or trading for wheat or whatever from time to time. IOW, oil may be (theoretically) fungible, but all markets are not. If you don't believe me, then simply tell me why £ are not used on London exchange for Brent? If you simply convert, then why not use £ and you can convert to $.
Don't most commodities have "only one price" globally because of arbitrage? But if oil is priced in USD only, then this arbitrage can't take place and the price of oil won't vary (others things being equal) with the value of the dollar. If the dollar rises or has an inflated value, other countries have to pay more for oil, but if the dollar falls, we still have the same buying power. In fact, we can take on colossal debts, expanding credit--and therefore the money supply--indefinitely, without suffering the inflationary consequences in terms of the world's most vital commodity. If other countries behaved this way, their currencies would collapse and they would pay much more for USD for oil...
This may not be the basis of US dominance etc., but it seems like a real advantage.
Now whether a small exchange starting in a country under threat of sanctions, with tense relations with most western countries, without (I would guess) a great deal of transparency in its legal and regulatory systems, and under constant threat of attack by the US and Isreal, can really grab a substantial share of the world oil market remains an open question.
Though if the dollar is mostly supported by "dark matter", it may be the symbolism that counts anyway.
p.s. many thanks to the admins and contributors for this great site.
As documented clearly here and elsewhere the primary strength of the dollar lies in the long term holding of dollar assets, which countries do voluntarily - not by its use in transactions.
But why do they do it? Why not to chose other currency instead? Hasn't that to do with the expectation that dollar demand will always increase?
There are dozens (if not hundreds) of economists saying that the US economy is heading for recession and that the dollar will crash.
Isn't that connected with the uncontralable US Energy Defecit (each year consuming more, each year producing less) ?
Great to be back discussing this with you. Here's my reply to your points.
The reason countries hold US dollar assets is twofold: expectations of higher returns than in other currencies and exchange rate management. I think the second is currently the more important. I don't think there is any expectation that dollar demand, at least for use as a currency in transactions, will increase.
Exactly. Fear for the future of the dollar has a rational basis - the fiscal position of the US. The US deficit(s) is a far more powerful threat to the role of the dollar than the IOB. Many mainstream economists think the dollar has to fall to recreate balance, but this has nothing to do with its use as a currency in transactions.
I don't think there is any expectation that dollar demand, at least for use as a currency in transactions, will increase
Well, they might not expect it, but in fact that is the case I believe. More transactions in dollars, more dollars will be bought. Even if I use the dollar just as a transaction currency, everyday I'll have to buy more to get the commodities I want. Remember that in the eighties we where in the 50 - 60 MDB range.
We both agree on the status of the US economy, the "Energy Deficit" is quite a good term in explaining what's going on. Although I belive IOB to be dangerous now, it wouldn't in case that Deficit didn't exist.
I have to disagree with you wen you say we must not mix the US perilous economic situation with the Oil Market. I believe that it is the Oil trading in dollars that made it so atractive to foreign countries.
Well Jack let's just wait and see. It won't happen all of a sudden in the Equinox, it'll probably go slowly at first. we'll only know for sure by the end of this year. And that is if no nukes come in to play.
Actually, I fundamentally doubt that the use of the dollar as a currency in transactions is of a significant volume (compared to holding assets long-term), or as prevalent as claimed here. Some international transactions are done using countertrade (ie. barter). I haven't seen anyone want to invade Thailand for trading chickens to Russia for fighter planes. I also don't think that Europe really converts to dollars to buy oil (or gas) from Russia. Again the dollar price is a measuring stick, but why wouldn't Russia accept Euros?
I didn't say "we must not mix the US perilous economic situation with the Oil Market." I just want to look at the IOB itself and not complicate and confuse issues by throwing everything else in the discussion as Gets It did above. I have accepted (in reality or for the sake of the arguement), that the dollar faces great risks, that purchasing oil has something to do with it, and that the role of the dollar is a benefit to the US.
However, if we want to discuss the IOB, let's discuss the IOB. I have found it somewhat frustrating that nobody really addresses my points or moves the discussion forward. Usually it ends in a broadening of the arguement to say the dollar faces risks and will get weaker (which I accepted at the start) or that I am some kind of Bush-loving, neocon, American apologist because I have the temerity to question the IOB as kryptonite claim.
But let's wait and see. I have enjoyed discussing this with you and think we are both just trying to figure it all out.
The international trade of goods and services is about $11 trillion. Of this 60% is dollar denominated (by memory).
At 60$/barrel, oil accounts for 27% of the total international trade denominated in dollars.
Other figures:
OPEC annual exports ~ $767 bln. Assuming conservative 10$ per barrel production costs these guys are having a net cash flow of $639 bln. A very convenient figure, almost enough to cover our trade deficit.
The bulk of the OPEC exports are used for OPEC imports. A few members of OPEC are piling up surpluses, but even they spend most if their monies on imports (including labor).
I would be interested in OPEC's Balance of Trade. Net $100 billion surplus would be my GUESS.
The whole magic of the petrodollar system is that these dollars finally end up rusting in some bank in Europe, China or Japan.
USA don't need to do anything, just enforce trade in dollars, countries of export havo no choice but to credit us unless they want to risk the well being of their own economies.
The special position of the oil in relation to other commodities is that first everyone wants it, so everyone wants dollars to get it. Second the high profitability of oil results in huge capital accumulations being easier to "recycle" e.g. by purchase of US weapons by Saudi Arabia.
Exactly. It can't just be a coincidence that trade deficit = oil in such a simple correlation. Its definately my suspect. How can anything (IOB) that may affect a component representing 25% of the problem be dismissed so casually? Not logical in my line of work. I'm waiting to see the sensitivity analysis, but in the meantime, I'm not discounting it. BTW, I have about 2400 USD in my entire world of wealth, so do I really GAS? I would like to know if I should buy more USD, but even if Goldman Sach's president told me to buy this very second and I'd make a billion, I'd have to think about it too long to take advantage of any "vision" they happened to see. I mean, what's a billion gonna be worth in a couple of years? I'd demand to talk to their oracal first face to face.
One element that's missing from this thread, however, is the element of control. In particular, US control of the world's premier strategic resource and quite literally, the life blood of a nation-state's economy and MUCH MORE IMPORTANTLY... it's military.
Today, oil is traded in US currency via US owned/controlled exchanges and I submit -economics notwithstanding- it is the element of CONTROL that matters most to US interests... mess with it at your own peril.
Case in point: Iraq.
Saddam challenges status quo through conversion of oil sales to Euros.
No one will be surprised to hear that I do not agree with his assertions here or elsewhere. Broadly he combines speculation with some basic economic misunderstandings that create story that sounds plausible. Note: my comments refer only to the IOB and dollar pricing of oil. These are not comments on the ongoing strength of the dollar or US economy, war with Iran, war with Iraq, US foreign policy, etc. I see these as entirely separate issues and mixing them only confuses things and gets people upset.
Clark purports that the Iran Oil Bourse, and more broadly trading oil in dollars, is the main threat to dollar hegemony. As documented clearly here and elsewhere the primary strength of the dollar lies in the long term holding of dollar assets, which countries do voluntarily - not by its use in transactions. In any mainstream economic discussion this point is not disputed.
As I have said before, a country that does not want to hold dollars can buy them moments before they make the transaction. This does involve holding some foreign exchange, but it can be Euros.
Clark also holds a few major misunderstandings of macroeconomics. Fundamentally, he seems to not understand what a price is and can't clearly explain how countries would actually switch to the Euro. More importantly, the majority of what he fears will happen actually already does.
First, oil can only be priced in one currency, although this price can reflect the value of the basket of currencies that it is traded in. Oil could be quoted in any currency you want, but this would only be a translation of the dollar price. Obviously of the price is different in different currencies, buyers will just trade in the cheapest currency.
Currently oil's price reflects its underlying value based on supply and demand. If that price were stated in dollars and translated into Euros or the other way around, the numbers would be the same. If Chinese demand causes the oil price to go up 10% and everything else stays the same, everyone bears the same price impact. The US, Europe and China all pay 10% more for oil.
Secondly, it is not true that the US faces no currency risk (and others do) because of the dollar price. As Econbrowser (see link below) noted, the price of oil already follows the basket of currencies in which it is traded in. It does not correlate to the dollar.
Clark claims that the Iraqi economy boomed and the Euro value jumped once that country switched currencies. If this is the case, one must assume that Euro countries and Russia are voluntarily accepting a massive tax on their economies to subsidize the US. Still the only reference Clark could cite from Russia was a response to a question put to Putin in 2003. I think it is odd that if this issue were really this important, it would not be met by such silence on behalf of two potential beneficiaries.
All of this gets no coverage by the MSM or mainstream economists (or Russia, or China, or the EU) not because there is any plot, but because they do not take it seriously. There are dozens (if not hundreds) of economists saying that the US economy is heading for recession and that the dollar will crash. But it is a small fringe group that claims the IOB has anything to do with it.
Luckily, this debate does not have to drone on endlessly. The question will be answered in one short month. Let's wait and see. My guess is that Iran will postpone again, because they like having a threat more than running an exchange that may or may not work, but won't trade non-Iranian oil and won't make any difference to anyone.
Here are two very good links. We have also had great discussions on this at TOD in the past.
Econbrowser: Strange ideas about the Iranian oil bourse
http://www.econbrowser.com/archives/2006/01/strange_ideas_a.html
Daily Kos (see comments)
http://www.dailykos.com/story/2005/12/27/115725/53
Very good insight. I liked the links too!
I view the IOB as a micro event, not a macro event.
I haven't made up my mind either way. I have serious doubts that the Iranian oil bourse will catch on, anyway, assuming it ever happens.
Clearly the US pressure on Iran is destabilizing and would make participating in the IOB more difficult. But this is not the only factor giving Iran massive credit risk. The IOB is a nonstarter as an international trading platform in any case. I think it is inaccurate to claim that the only - or main - reason why Saudi Arabia (for example) would not trade on the IOB is US pressure.
- In theory what is the currency of the transaction may not matter. But in practice it does matter big time. First the exchange rate risk is priced very expensively by the market as evidenced by the huge foreign currency reserves the central banks hold.
- There are also the transaction costs and the risks associated with them (they are also widely fluctuating).
- Third, and most important actually is that the only reason to prefer one currency against another is confidence in it. In a fiat currency world confidence is based only on the perception that the currency of choice will be valuable and demanded in the future. If you don't have that confidence you will simply pick another one.
I call your claims "voodoo economics" because these are the type of assertions economists use to induce self-fullfilling wishful thinking in the markets. The funny thing about economics is that virtually any theory or prediction may become or be true within a certain timeframe if you wish and believe in it. If you wish something you start believing in it, if you believe in it, then you make the corresspondent investment decisions. If the majority of market players make the same investment decisions your wish is coming true!That's what it's all 'bout.
I think this at the heart of the IOB issue. People wish the dollar would weaken, know that there are reasons why it should, then assume that the IOB is the answer. I have agreed that there are risks facing the dollars and that it should weaken. But this doesn't make me beleive that the bourse is kryptonite.
You didn't say "Voodoo Economics" you said "Economics Voodoo Magic" which I liked a lot better. Voodoo economics usually refers to Reagan's supply side theories, which have absolutely nothing to do with what I have said. Calling any of it "Wishful thinking" is a case of seeing what you want to see. I have not said a single positive thing about the dollar and there is nothing in my claim that says it won't go up in smoke. I am happy to accept for the sake of the arguement that the dollar could crash and no longer be the global currency. What the IOB has to do with this is unclear.
I am trying to have a analysis-based discussion on the IOB and the fact that everyone wants to insult me and change the subject certainly hasn't made me doubt that I am right.
Your third point above is the most significant. But again the important issue is holding US dollar assets long-term, which is still being done. Nothing that you have said provides any evidence that the US of the dollar as a measuring stick underpins the empire.
Personally I don't want anything like that. I'm simply trying to reject the opposite type of wishful thinking that has supported our bubbling economy through the years and is driving the risks to the skies. My opinion is that we should try to attempt soft landing before it is too late.
I am trying to have a analysis-based discussion on the IOB and the fact that everyone wants to insult me and change the subject certainly hasn't made me doubt that I am right.
I don't see an insult here, neither change of the subject. Pumping up an economy without exports and a disappearing industrial base like there is no tomorrow has lots to do with wishful thinking and little to do with economic fundamentals.
But again the important issue is holding US dollar assets long-term, which is still being done.
And so what? If things start unwinding whether you hold a one year or 30-year asset is all the same - you still have a hot potato you will try to pass on to the next dummy.
I think you missed the main point of number 3). The value of the dollar is based on perceptions. IOB might take a minor share of the dollar trade. But the risks that it would change the perceptions of the major players are enormous. The scenarious that can develop vary but the least that can happen is that FED will be forced to raise more aggressively interest rates to pay for the rising risk premium the dollar will be charged with. We may need to pay with a forced recession, and with debt levels to unprecedented heights this could get very ugly.
I think I will not exaggerate if I say that if significant portion of the world trade switches to euro this would mean the end of the independant monetary policy of US. For all practical purposes this would be equivelent to the end of the US empire.
You are correct that unemployment increases any time growth in real GDP declines below about 3.5% for any substantial length of time. The main justification for economic growth is that it is necessary to keep the rate of unemployment down.
The problems of coming to grips with a steady state economy have not been worked out even in theory, much less in practice.
On the other hand, bearing in mind the overexposed external position of the US economy, I can't see some mild scenario of 10% inflation and moderate unemployment... it will probably be either or. My best case scenario would be a moderate recession and a gradual reduction of the debt in the next decade or two.
I do think you are changing, or at least avoiding, the subject. I have acknowledged every economic point that you make in your post, except the last one.
I do not accept the point that there is much causality between the currency that countries trade in and the currency that they hold assets in. I suspect the most likely case is that the world continues to trade in dollars, but that there is a reversal of the desire to hold dollar assets. So my scenario is as pessimistic as yours. I'm just not buying into the party line that dollar trade underpins US strength and that the IOB is the weak link.
I see the IOB myth as a Star Wars fantasy. People want to believe that the US is the Deathstar, but that it has a fatal flaw that can easily bring it all down. I don't see it this way.
My point was that I keep saying that the dollar and US economy may have serious problems, but that the IOB is not one of them. The most common reply is to attack the first half of the sentence, where I have already agreed with you.
If you were to separate out all of the rebuttals to my IOB arguments that really refer to the IOB (not rebutting things I have accepted) I think you would find that they are brief, petty and unsubstantiated.
Your claim of battling wishful thinking is again attacking a windmill that doesn't belong to me.
This is a very disputable point at the least. I would compare it to the idea that there is no connection between voltage and the electrical current. Yeap, there are other factors like resistance, self-induction etc. but trade is the reason why foreign funds get accumulated at the first place and a claim that there is "not much causality" is... let's say strange. If we assume that there is no causality then we will need to explain why the funds held internationally in New Zealand, Canadian or Australian dollars for example are such miniscule amount compared to US dollars or Euro. The connection between trade and funds for different economic agents varies, but I would rank it this way:
- Central banks prefer to hold foreign currencies which are demanded domestically, especially for imports. Especially for strategic imports like energy.
- Importers need the currency of import and usually hold foreign currency accounts to hedge against currency risk.
- Commercial banks prefer to hold foreign funds liquid within the country their operate in - that is if a country does not trade with Australia a commercial bank will have less reasons to hold Australian dollars.
- Hedge funds, individuals and other "secondary" players may have more speculative reasons and invest in less demanded currencies (because of higher interest rates etc.) but in such cases they have to pay a much larger margin.
I'm sorry but I think your point is a little bit "US-centric". If you live in US you get the feeling that international money markets are like groceries - you go in and just buy the funds you need. The reality is that if your currency is demanded internationally it is almost like that, if it is not you need to use another currency as a medium which is equivelent to forcefully credit the country that emitted it. Very convenient isn't it?You are right about the area of our disagreement, but none of your follow up points do much to advance your view. Of course countries need to hold foreign exchange if they want to trade. But is doesn't have to be dollars unless they trade with the US. Even so, they can convert at the time of purchase. International currency markets are the largest, most efficient, and most liquid market in the world.
Again, the real issue is the currency in which long-term assets are held. Why does China hold 70% of their reserves in US dollars? You seem to think it is because they have received them and find it too difficult to convert other currencies. This is wrong. I don't think anyone really believes that the currency balance held by banks in Korea, China, Japan, etc. is determined by what they receive in trade.
These countries have a strategic plan for their currency holdings based on return and exchange rate management. It makes no difference what currencies they receive through trade. They will convert and adjust to meet this strategy.
You say `trade is the reason why foreign funds get accumulated at the first place and a claim that there is "not much causality" is... let's say strange." This is also wrong. It is analogous to saying that you receive your income in one dollar bills so you keep your savings in one dollar bills. My claim above that countries determine the balance of their currency holdings based on return and exchange rate considerations is the undisputed mainstream view. The reason that countries such as China do not hold large amounts of New Zealand dollars in because that currency is regarded as riskier in capital markets, lacks the depth of the dollar and is not liquid. Just because you don't the like the fact doesn't make it untrue.
I think you have a fixation on US-centric, wishful thinkers, which is distorting your perceptions. If you leave that out of future posts they may make more sense.
And why is it not "liquid"? And why is it "risky"? Are New Zealand or Canada dangerous places to make business with? What can China buy with New Zealand dollars? Sheep?
I think at another place I pointed out that 60% of all international trade is being done in dollars. Countries trade in dollars that's why they prefer to keep dollars to buy what they want at any time without paying for the risks and the transaction costs. The less a currency is traded with, the more it is "risky" and the less "liquid" it is which is the another way of sayng that transaction costs are higher.
What you keep staring at is the secondary market where agents redistribute their foreign currency portfolio between themselves but the primary reason for them to have a portfolio at the first place was just one: trade. Money without anything you can buy it with is plain paper.
Sorry I don't have what else to say except that "international trade is the underlying reason for accumulation of foreign funds" was stolen from my books of International Finance. I'd like to see what yours say.
You are right that:
LevinK: I think what we do not agree upon comes down to (Jack's claim) here: "I do not accept the point that there is much causality between the currency that countries trade in and the currency that they hold assets in."
However, I think that our disagreement is part substantive and part semantic. So here is an attempt to clarify my meaning and some terminology:
- Foreign Exchange Reserves (FER) are a subset of the total assets that a country holds in foreign currency denominations.
- FERs (see definitions below) are short term liquid assets that are used to finance net payments to foreigners and intervene in currency markets.
- Countries need to draw down FERs only when they have to make a net payment to foreigners (Eun/Resnick - see below).
- Countries also hold long-term assets, which are equally important. A dollar is a dollar, regardless of what class it is held in.
- The holding of US dollars assets by the largest holders (China, Japan, Korea) are greater than their need to make trade related payments by a huge amount. Actually, most if not all of these countries have balance of payment surpluses and no requirement to make net payments to foreigners.
- Only a tiny portion of the assets held by these countries can be explained by the need to make trade payments.
- A complete removal of US dollar pricing of commodities, including oil, could lead to the value of dollar based foreign exchange reserves that are held shrinking to something more in line with the value that each country trades with the US. However, this is a process that has been ongoing. The dollar as a portion of FER has shrunk from 68.6% in 1980 to 57.1% in 1997.
- It is the currency that countries hold over the long-term that makes a difference, not what is used in trade. As I said above:
"Again, the real issue is the currency in which long-term assets are held. Why does China hold 70% of their reserves in US dollars? You seem to think it is because they have received them and find it too difficult to convert other currencies. This is wrong. I don't think anyone really believes that the currency balance held by banks in Korea, China, Japan, etc. is determined by what they receive in trade.These countries have a strategic plan for their currency holdings based on return and exchange rate management. It makes no difference what currencies they receive through trade. They will convert and adjust to meet this strategy."
These points by Professor Hamilton at Econbrowser (http://www.econbrowser.com/archives/2006/01/strange_ideas_a.html)
should provide ample evidence of this:
"you don't need to acquire any U.S. assets in order to purchase a barrel of oil that is priced in dollars."
"the key question in my mind is what asset do the oil producers want to be holding immediately after they've sold the oil? If what they want to hold is U.S. Treasury securities, then I agree with you, the transaction has led to an increase in the demand for dollar-denominated assets. However, if that is their desire, I see no reason why they wouldn't do exactly the same thing if the sale were transacted in euros, namely, use the euro proceeds to purchase dollars for the Treasuries. Nor, if what they ultimately want is euro-denominated assets, does anything prevent them under the current system from immediately converting the dollars into euros. This is why I suggest that it is the final demand for assets rather than the unit of account of the transaction that is of primary importance."
"I will grant you that somebody must hold some extra dollar-denominated assets during the time it takes to complete the transaction itself. However, I expect that the contribution this makes to the demand for U.S. base money (the sum of physical dollar bills plus Federal Reserve deposits) is unlikely to be very large, and certainly not something that could cause the end of an empire, as if the total seignorage the U.S. collects from all sources were all that huge in the first place. "
9. According to The Federal; Reserve Bank of San Francisco (http://www.frbsf.org/publications/economics/letter/2003/el2003-11.html), "Since the 1997-1998 Asian financial crises, monetary authorities in emerging markets in East Asia have more than doubled their stockpiles of foreign exchange reserves; by the end of May 2002, they held $845 billion, or 38% of the world total. Of these countries, China, Taiwan, Hong Kong, South Korea, and Singapore rank just behind Japan as the world's biggest holders of foreign exchange reserves--together those five countries hold reserves totaling nearly $700 billion." How do you see this doubling as linked to trade?
My Int'l Finance Textbook agrees with yours and states that "the dominance of the US dollar (as a FER) may be attributable to the fact that roughly half of world trade is invoiced in dollars. Most commodities are priced in dollars". I do have to acknowledge that international trade and dollar pricing does play a role in accumulation of the portion of short-term reserves that is attributed to making net payments to foreigners.
But my claim is that this is a small portion US dollar assets held by foreign countries. If this dollar dominance were to be eroded, the impact on the US would be somewhat negative. It is conceivable that the IOB could be a small factor in this happening. I have never disputed this.
My contention has always been that the threat from the IOB is microscopic in comparison to two other threats to the US economy and role of the dollar, both real:
1) Iranian Oil resources
2) Waning interest in holding long-term dollar denominated assets by foreign countries.
Given that there are real issues, I wonder at the amount of efforts committed to pumping up the IOB, which I see as a diversion at best. I maintain my position that the IOB scare is a conspiracy theory on steroids.
DEFINITIONS:
Foreign Exchange Reserves
Liquid assets held by a central bank or government of a country, for use in intervening in the foreign exchange market.
http://www.lse.co.uk/financeglossary.asp?searchTerm=foreign&iArticleID=1902&definition=forei gn_exchange_reserves
Wikipedia Foreign Exchange Reserves
Purpose
Reserves can be used by the country's central bank to purchase the country's currency in an intervention. This allows it to control the exchange rate; increasing demand for the country's currency increases its value as compared to the currencies of other nations. Countries often have reserves because they fear speculation and economic shocks might affect their exchange rates, and they want to be able to keep their rates steady.
http://en.wikipedia.org/wiki/Foreign_exchange_reserves
TEXTBOOK:
International Financial Management
Eun/Resnick
McGraw Hill
- Exchange rate management in the case of central banks
- Receiving a higher yield
- Expectations for speculative gains
The core of my argument is that in the medium to the long run all of them are dependent on the demand for dollars for transaction purposes:1) The central bank reserves are overwhelmingly accumulated by purchases from the domestic market. If country agents do not use dollars for trade, the banks will accumulate euros or whatever they use. If it stubbornly converts those euros to dollars it will have to continuosly go to the international market every time its residents sell or buy their euros.
China and Japan have USA as their most important trade partner, and the impact on their official reserves is evident.
2) Higher yelds attract investors but if a currency is considered risky the yield premium must be higher. Example: current USD/EUR IR differential is above 2% but the dollar has not appreciated significantly. The reason is that there is a risk premium payed by US government because the dollar is already considered risky.
How risky is a given currency is directly related with demand for it as a transaction currency. New Zealand dollars are not demanded by agents because you can not buy lots of things with them. A currency that is not used in the international trade is prone to huge fluctuations - if you buy lots of NZ dollars it will appreciate and then probably depreciate with time. Investors need security and therefore invest in funds that will be liquid and demanded in future.
What is the term structure if your portfolio is absolutely irrlevant to this discussion. China's national bank does not have to wait 30 years to cash its US bonds if its residents need US currency. Or if they start demanding euro it does not need to wait 30 years to restructure its assets.
3) Speculative gains funds are short-lived and are directly related to funds 1) and 2). Speculators continuously monitor where the major players (central and commercial banks) direct their funds and rush to follow them and profit from the currency appreciation/depreciation.
I searched for statistics to compare the portion of foreign assets in dollars in 1980 and 1997, but could not find any. I would bet though that it has gradually declined along with the portion of dollar in foreign trade.
I would sum it up:
- The impact of trade on foreign currency funds is very significant, but comes with a lag which may last years.
- The impact of IOB may not be significant as a portion of trade but will adversely affect the perceptions of the traders, escpecially speculators. This effect is generally unpredictable and introduces the major risks in that game.
Market shows that agents pay for risks big time. I can deduce that USA is willing to pay for this risk even with war if needed.Sorry for the long post, I hope I made my points clear.
However, it's axiomatic that in politics and international affairs perceptions are at least as important as reality. And in that regard, I suspect the rulers of the US are quite upset over the IOB, if for no other reason than that it exists at all and that it represents an extended middle finger in the face of the omnipotent US.
They are probably also worried about countries with a grudge against the US and the UK switching from New York and London to the IOB just out of spite. And it could set a precedent for countries avoiding the dollar in other types of transactions. So perhaps the IOB is just a secondary reason why the US has it in for Iran - its overt hostility towards Israel and its alleged nuclear weapons program being the primary ones.
If the dollar Euro exchange rate is one dollar to .8 Euros. What difference does it make if a unit of oil is priced at one dollar and translated into .8 Euros or priced at .8 Euros and translated to one dollar? It has to be in one currency for consistency. It could be Euros as well as dollars, but this is like claiming that using the metric system would bring down the empire. You can get over a wall just as easily whether you measure it in inches or millimeters.
Cars, oil, anything can be priced in Euros. But it wouldn't change anything. It is just a price. Likewise a race can be measured in miles but you would be foolish to say I can't run 16 kilometers, so I'll only go ten miles. The price is no different. Euros, dollars, miles, kilometers. None change the underlying reality. But you need to measure in one unit all the time.
You say that converting currency is an expensive step on the ladder that keeps bankers fat and happy. Look up the dollar-Euro spread some day. It is not expensive. And I claim that Euro is buying oil from Russia in Euros already. I don't believe they are converting to dollars. They only use the price as a measure to see how many Euros. I have made this claim before and it has not been refuted. If I am right it makes a mockery of the whole IOB claim.
When I say the majority of what he fears already happens, I refer to:
1) The US bearing currency risk: They already do as oil follows a basket of currencies and is not correlated to the dollar. The US bears the same risk as everyone else.
2) The idea that pricing oil in Euros requires the use of dollars is not really true. Countries can hold Euros, convert to dollars and buy oil. The seller can then convert to Euros if this is what they want to hold. If this was all done through one institution, the funds are in dollars for less than one second and in Euros for a long time. The claim that removing this one second of dollar use will bring the US down is absurd. As I said above, I do not believe that Europe buys oil from Russia in dollars. They follow a dollar pricing system, but what is stopping them from agreeing to use Euros? Nothing. The price is not a requirement of currency use. I am sure that European oil trade with Russia is effectively done in Euros right now.
You say the dollar will fall and is intrinsically worth nothing. Fine. No disagreement from me. But this has nothing to do with the IOB.
You wrap up by assuming that I am defending the US and the dollar although I explicitly said I was not. You can mix up these arguments all you want, but you are not making any point. I have admitted the dollar has weaknesses. I don't make any claim regarding what will happen to it. However, your long rant barely addressed the key point. The IOB won't change anything.
Thanks,
Rick
What puzzles me is the widespread belief by some people who post here that they can obtain solid knowledge easily, quickly and without effort. Sorry, the world does not work that way.
If you want an easy read with no graphs and no algebra but great prose and wit, get any edition of THE WORLDLY PHILOSOPHERS by Robert L. Heilbroner. From this book you'll pick up a lot of lovely tidbits you can use at cocktail parties, but more important you will get an appreciation for how economists think. Yes, good idea: Start with that book, and I'll recommend others from time to time.
Oh how true.
I see it in my work all the time.
Amazingly, it is these same people who send their partially-matured kids to college for 4 or more years --at great expense-- to learn that which they claim can be acquired with a few well-barked sound bites (e.g., what is thermodynamics?, what is physics?, what is economics?, etc.). Can't they see how foolish it is to send kids to school when it can all be internalized with a few minutes of effortless osmosis?
But then again, "common" sense is for the "common" among us.
Keep up the good fight :-)
I detest elitism.
thank you.
our country owes you gratitude.
as one who has been lucky to have a few good teachers cross my path, I am always humble to remember that I am not a self-made person but instead a product of the dedicated efforts of all those great educators.
BTW, I know how a bumblebee flies. This "problem" was solved at least twenty-five years ago.
First, I see the demand for holding US $ and US assets being sated and "eventually" creating a glut. The Central Bank of China (previously 70% US $) has talked about "diversifying". As a major holder they have no incentive to talk down the US $.
When will the break occur, when will the desire to hold US $ vs. Euros, yen, won, Swiss Francs, Aussie, Canadian & NZ $, etc. change ?
When a panic sets up IMHO (and observing other currency runs). A panic is based upon market psychology.
There is an unconscious, and not very logical link between holding dollars vs. other currencies and getting what I want (oil for example) because it is priced in US $.
Does the illogical have more impact upon the less experienced (say Central Bank of China) vs. more experienced (say Bank of England) ? Don't know but expect so.
Logically, one cannot use dollars to get what one wants from the US directly because there is not that much one wants from the US (see Balance of Trade) and there are LOTS of US $ floating around and more every day ! The US $ is more useful for 3rd country transactions.
A sudden break in oil transactions from US $ to Euros may well be the catalyst for a break down in confidence. Or it may be something else ($100 oil for example, or problems with US mortgage market or ...).
A break down that will occur in any case "sooner or later" due to our huge Balance of Trade and Payments deficits.
I'm making a preliminary bet for 60-70% correlation - when oil goes up, so is gold and the dollar tanks. With oil being the cause and the others - the effect. I think all the information we are talkng here is pretty much incorporated within the markets. Everyone is waiting it to happen, but fear (long-term thinking) has a long way to overcome greed (short-term thinking). They will try patching the situation with higher interest rates for a while, but if oil gets to 100$... clearly anything is possible.
Don't most commodities have "only one price" globally because of arbitrage? But if oil is priced in USD only, then this arbitrage can't take place and the price of oil won't vary (others things being equal) with the value of the dollar. If the dollar rises or has an inflated value, other countries have to pay more for oil, but if the dollar falls, we still have the same buying power. In fact, we can take on colossal debts, expanding credit--and therefore the money supply--indefinitely, without suffering the inflationary consequences in terms of the world's most vital commodity. If other countries behaved this way, their currencies would collapse and they would pay much more for USD for oil...
This may not be the basis of US dominance etc., but it seems like a real advantage.
Now whether a small exchange starting in a country under threat of sanctions, with tense relations with most western countries, without (I would guess) a great deal of transparency in its legal and regulatory systems, and under constant threat of attack by the US and Isreal, can really grab a substantial share of the world oil market remains an open question.
Though if the dollar is mostly supported by "dark matter", it may be the symbolism that counts anyway.
p.s. many thanks to the admins and contributors for this great site.
But why do they do it? Why not to chose other currency instead? Hasn't that to do with the expectation that dollar demand will always increase?
Isn't that connected with the uncontralable US Energy Defecit (each year consuming more, each year producing less) ?
Great to be back discussing this with you. Here's my reply to your points.
Well, they might not expect it, but in fact that is the case I believe. More transactions in dollars, more dollars will be bought. Even if I use the dollar just as a transaction currency, everyday I'll have to buy more to get the commodities I want. Remember that in the eighties we where in the 50 - 60 MDB range.
We both agree on the status of the US economy, the "Energy Deficit" is quite a good term in explaining what's going on. Although I belive IOB to be dangerous now, it wouldn't in case that Deficit didn't exist.
I have to disagree with you wen you say we must not mix the US perilous economic situation with the Oil Market. I believe that it is the Oil trading in dollars that made it so atractive to foreign countries.
Well Jack let's just wait and see. It won't happen all of a sudden in the Equinox, it'll probably go slowly at first. we'll only know for sure by the end of this year. And that is if no nukes come in to play.
I didn't say "we must not mix the US perilous economic situation with the Oil Market." I just want to look at the IOB itself and not complicate and confuse issues by throwing everything else in the discussion as Gets It did above. I have accepted (in reality or for the sake of the arguement), that the dollar faces great risks, that purchasing oil has something to do with it, and that the role of the dollar is a benefit to the US.
However, if we want to discuss the IOB, let's discuss the IOB. I have found it somewhat frustrating that nobody really addresses my points or moves the discussion forward. Usually it ends in a broadening of the arguement to say the dollar faces risks and will get weaker (which I accepted at the start) or that I am some kind of Bush-loving, neocon, American apologist because I have the temerity to question the IOB as kryptonite claim.
But let's wait and see. I have enjoyed discussing this with you and think we are both just trying to figure it all out.
At 60$/barrel, oil accounts for 27% of the total international trade denominated in dollars.
Other figures:
OPEC annual exports ~ $767 bln. Assuming conservative 10$ per barrel production costs these guys are having a net cash flow of $639 bln. A very convenient figure, almost enough to cover our trade deficit.
I would be interested in OPEC's Balance of Trade. Net $100 billion surplus would be my GUESS.
USA don't need to do anything, just enforce trade in dollars, countries of export havo no choice but to credit us unless they want to risk the well being of their own economies.
The special position of the oil in relation to other commodities is that first everyone wants it, so everyone wants dollars to get it. Second the high profitability of oil results in huge capital accumulations being easier to "recycle" e.g. by purchase of US weapons by Saudi Arabia.
One element that's missing from this thread, however, is the element of control. In particular, US control of the world's premier strategic resource and quite literally, the life blood of a nation-state's economy and MUCH MORE IMPORTANTLY... it's military.
Today, oil is traded in US currency via US owned/controlled exchanges and I submit -economics notwithstanding- it is the element of CONTROL that matters most to US interests... mess with it at your own peril.
Case in point: Iraq.
Saddam challenges status quo through conversion of oil sales to Euros.
Response: invasion.
Primary objective: oil infrastructure.
Result: foreign oil contracts dissolved, oil sales re