The Oil Drum

Brian,

Though this is yet another nail in the US financial coffin, not so fast.

The term "reserve currency" is completely detached from banknotes, so in that regard the FT article has little impact. Americans probably need less paper, because they use more plastic; total "flow" is still much higher in the States.

In the 1990's there was a report that said only 3% of all "money" in the UK was banknotes, the rest was "virtual". If the percentage would be the same now in the EU and US, the $800 billion in banknotes in both regions would represent some $25 trillion in total available "money". The mortgage- and other-credit craze in the US since 2000 would make us fear that it's much more than that, though.

A few days ago, the New York Times ran an editorial by Ben Stein, who parrots Bernanke's statements about a "global savings glut". The idea would be that the Japanese and Chinese save so much, it allows them to buy all those US securities, bills and bonds.

Prof. John Succo at Minyanville refutes that idea and describes what he thinks really goes on.

The Federal Reserve creates credit through its open market operations like REPOS and coupon passes. If the Fed wants to inject liquidity (credit) into the system, they simply call up large broker dealers and buy some of their bonds with credit they create out of thin air (this expands their balance sheet). The dealer then passes this credit on to “the market” by making loans to mortgage companies or margin accounts or whatever. Because each layer of lender is only required to keep marginal capital on hand, a $1 billion REPO done by the Fed eventually creates as much as $100 billion in new credit to the consumer.

That credit creates the liquidity for additional consumption in the U.S., but these days we are buying our stuff from China (other countries too but we will just say China to make it easy). When a Chinese company receives dollars in trade, this normally would drive up U.S. interest rates: the company goes to the central bank of China to exchange Yuan for dollars; the central bank of China would normally sell those dollars into the currency market for Yuan thus driving up U.S. interest rates. But in our world of today these dollars are being sterilized: the central bank of China prints the Yuan to give to the company and takes the dollars and buys U.S. securities

Prof. Succo doesn't say it in so many words, but the Chinese do something similar to what the Fed does. He says they print yuan, but of course they have figured out fractional banking as well.
In theory (just to be careful), the original $1 billion Fed REPO sends $100 billion to China, where it's used for two purposes:

1. A Central Bank purchase of $100 billion worth of US securities, which is collateral for:
   (note: the Chinese are not yet as nuts as the Americans)
2. Trillions in money available to the domestic market

We don't just use our homes as ATM machines, we use China for the same purpose. If I spend $100 for every dollar I earn (or print), by borrowing ever more, how nice will my creditors be to me down the line if I can't pay them back?
I can tell you: they'll take my TV, my car, my house, my wife, everything, Now I can think I have the biggest muscles, and the biggest guns, but I can never kill them all, and that means I'll have to pay someday.

What's worse for the US in the short term is that the creditors will start applying pressure on the loans, the Euro is much better for them, they want to cash in their US securities and move them. Or charge more interest. Total US debt is around $40 trillion, not counting Medicare and Social Security. That means interest payments (not principal) of around $3 trillion per annum, for an economy with a $12 trillion GDP. Time to move to Albania?