Taunter Media

Economista Non Grata asks about the rumors that the dollar will be replaced as a reserve currency.  Allow me to try to get to it via something completely different – the Krug’s excellent diagram of what is going on in Bernanke’s mind:

There are times I kick myself for not coming up with stuff like this myself.  Then I realize I don’t know how to post my own graphics to WordPress.  And I don’t have a Nobel Prize.  So I’m going to have to use a lot of words.

As Paul points out, once upon a time – not that long ago, actually, well within the memories of many people who are alive today – the entire banking system was: people deposit money in banks, banks lend money to borrowers.  The end.  Well, then the whores…

Then we developed the shadow banking system.  All of a sudden a variety of securities were developed that allowed investment banks to direct the public’s money directly to borrowers.  No more pesky assets taking up space on a commercial bank’s books.

This was so much fun – and so profitable – that even the commercial banks got into the game.  The money centers branched out into investment banking and little Main Street banks, ever desperate to get into the hustle and far as ever from knowing how to tie their shoes, bought the crap products sold by the money center banks.  It was a glorious game, and with so many pieces in motion, no one had the foggiest idea who owed what to whom, much less how robust all the middlemen standing between borrower and lender might be.

When Lehman came crashing down, everyone ran to put money back into banks and money markets, especially since the government guaranteed these investments.  But as Krugman points out, the banks looked out the window and saw declining credits and had no desire to lend to retail borrowers.  Better to park what money remained at the Fed and hope to ride out the storm.

This bred the Bernanke banking system – the Fed started diving into the credit markets to deploy those deposits, turning itself into some sort of giant adapter between the banks and the markets.  The big debate in DC is how to get the Fed out of this rather uncomfortable role.

Krugman asks the insightful question:

why does it have to be a return to shadow banking? The banks don’t need to sell securitized debt to make loans — they could start lending out of all those excess reserves they currently hold. Or to put it differently, by the numbers there’s no obvious reason we shouldn’t be seeking a return to traditional banking, with banks making and holding loans, as the way to restart credit markets. Yet the assumption at the Fed seems to be that this isn’t an option — that the only way to go is back to the securitized debt market of the years just before the crisis.

The cynical answer would be that the economic team is beholden to the finance elite.  It is difficult to make an enormous amount of money in the pure commercial banking side, because the return on invested capital simply isn’t that high – a few basis points of spread and all the downside risk, and for that you have to tie up a huge amount of capital for a long time.  What can a person be paid to oversee such an operation?  By contrast, a dynamic industry that can move an enormous amount of other people’s money without needing to use very much of its own money on a time-weighted basis – say, the capital markets businesses – are far more lucrative and far more concentrated in their rewards.  That’s the capture argument.

But perhaps a more simple argument is just that we assume we must return to the world of early 2007 because we remember that time well and remember thinking that everything was fine in the world.  The fact that all of the problems that would ultimately lead to the credit crisis were even then incubating in our economy wasn’t known at the time, and it’s that ignorant bliss we want to recapture.  A bit like the Netherlands granting sanctuary to Kaiser Wilhem after World War I and the other European nations respecting it; after the trauma, it’s human to seek whenever you last felt normal.

I see a bit of that in the currency world, which may only go to show that I know precious little about currencies.

The US grew prosperous without the dollar having great global importance.  Most of our history was spent on the gold standard.  China’s tremendous leap from absolute destitution thirty years ago has taken place with a barely convertible currency.  Are we sure that having the dollar be a reserve currency – or the currency of record for quoted commodities – has that much impact?

For all their denials, suppose the Gulf states decided to price their oil in Euros tomorrow (or renminbi, or gold, or whatever) and what had been $69/bbl was now a bit more than €47/bbl.  What would that do to us?  Suppose the Euro then rose to $3=€1.  What would happen to the price of oil?  The Daily Kos answer would be that it is now $142, with some rounding.  But wait a minute.  The old $69 price represented an equilibrium based on all consumers.  Consumers who perceive the dollar/euro exchange rate move as affecting the amount of oil they can purchase for their dollars will buy less oil.  Which will drive the price back down.  We are simply expressing the same problem – global demand for oil at prevailing purchasing power – in different units.  Big deal.

Now about exchange rate movements themselves.  The Euro/dollar rate is hard for me to process, involving as it does tremendous financial system movements that dwarf actual trade.  When the Euro was launched the idea was that purchasing power parity would happen roughly around dollar parity; that was the reason for launching at $1.17 as opposed to, say, $5 or $10 or $1 (never ceases to amaze me that there are people who believe that a country’s wealth is determined by the absolute number of its currency to the dollar – as if Mexico were richer than Japan because there are multiple yen to the peso; they must be related to the people who believe companies with $50 stocks are larger than companies with $25 stocks).

I will note one weird historical rule of thumb – since American independence, the Franc/dollar rate has the odd habit of reverting to FRF 5 = USD 1 (the equivalent of $1.31=€1.00).  Like the Bermuda Triangle, I suspect you could tell whatever story you wanted by finding some historical relationship of a predecessor currency; I certainly do not recommend trading on it.

China is the one that we hear the most about, and the one that I find the most overblown.  The Chinese have essentially chosen to vendor finance American purchases.  It’s a bit of a weird decision for a nationalistic place, because it puts an awful lot of faith in us.  You see, we aren’t going to pay it back in any meaningful way.  Sure, we will give them pictures of George Washington on schedule, and borrow more from them.  But the pictures only have real value to the Chinese to the extent that they are able to get something useful back to China with them.  And any widespread move to repatriate the money would alter the exchange rate and give them far less stuff than they would be entitled to get today.

Look at it this way: China’s dollars are the simple outcome of their current account surplus with us.  They ship us stuff and we give them dollars.  If they bought our stuff and gave us back the dollars, they’d get stuff to take home.  But for a variety of political reasons, they don’t want to buy our stuff.  So they sit on the paper and it builds up.

If someday the dollar crumbled against the renminbi, what would happen?  We’d buy a lot less stuff from China.  We’d have to get our cheap goods from Vietnam, or heaven forbid, from ourselves.  The Chinese would have a much easier time buying our stuff…and there would be a lot of laid-off Chinese in export industries.

Who is the big loser in that scenario?  We don’t want to rock the boat of having the flashy currency, but they are the ones who have to make a massive adjustment if the currency actually moves.

Furthermore, imagine that the renminbi were the currency of choice in international transactions.  That means that Chinese buyers would pay for something overseas – oil, gold, tacky belt buckles – in renminbi.  Do it enough times and the volume of renminbi outside of China is bound to grow.  That growing Eurorenminbi market robs China of its control of its currency the same way the Eurodollar market forced the US to abandon the gold peg.  The Chinese fear this a lot more than having to look at a picture of a dead white guy while on vacation.

Ultimately we have control of our financial house, whether the rest of the world wants to list its goods in dollars or not.  I share the gut feeling that there is something about a strong currency that tends to be associated with economic success, but I strongly suspect that’s an emotional reaction.  There’s something nice about landing in the airport of a hostile country and seeing the flag carrier’s lovingly maintained Boeings – you can dance on our flag much more easily than you can replicate our enterprise – but lack of a commercial aerospace industry does not make Norway poor.  Few of us can remember a weak dollar, so it doesn’t seem right, but it’s hard to think of a reason it would be a tremendous problem.  The deficits that destroy the dollar are much bigger threats.  I would like us to run a balanced budget at the middle of the economic cycle, although the US government that actually does so is probably a figment of my imagination.