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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.