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The Denigration of the Dollar and the Fed

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For decades the U.S. has had the luxury of printing dollars while the rest of the world produced the things dollars can buy. The world has long prospered on this debt-fueled credit binge, but all good things come to an end, and we are witnessing the gradual deterioration of the U.S. dollar. The recent S&P downgrade of the U.S. government (USG) and ongoing political gridlock in Washington has sapped whatever confidence remained in the dollar as the world's dominant reserve currency. In addition, the machinations of the Eurodollar market have succeeded in denigrating both the value of the dollar and the Fed's ability to do its job.

According to a report by the Division of Monetary Affairs from the Federal Reserve, in the current decade U.S. monetary expansion has been driven by external demand for the dollar. $100 notes are the largest denomination issued by the Federal Reserve, which make up 60 percent of the value of all the U.S. currency outstanding, and demand for them comes predominantly from outside the U.S. Since the 1990s, the overseas stock of dollars has been growing about three times faster than the domestic stock on average. Typically, the amount of currency outstanding typically grows in sync with, or even more slowly than, consumption in the U.S. Indeed, this was the pattern until 1990. Consistent with growing external demand for dollars, the U.S. currency has grown about 3.5 percent more rapidly than consumption in nominal terms.

Some may be inclined to suggest that these overseas dollars would be used to buy goods and services from the U.S., thereby boosting the U.S. job market. Nothing could be further from the truth. The majority of the overseas dollars are parked in treasuries and other dollar-denominated securities and assets through official foreign exchange holdings and the Eurodollar market. According to Professor Robert Blecker's research, by the end of 2009, foreign central banks had assets of $4.4 trillion in the U.S., which were 60 percent higher than the overall U.S. net debtor position of $2.7 trillion. That is to say, excluding its colossal debt to foreign central banks, the U.S. was still a net creditor country to the tune of about $1.7 trillion in its other unofficial (i.e. non-central bank) international financial activities as of year-end 2009.

Hence, the expanding foreign accumulation of U.S. assets after 2000 was not primarily driven by increased confidence in the U.S. economy or U.S. assets by private-sector agents abroad. On the contrary, it was primarily foreign central bank intervention that financed the growing U.S. twin deficits. Dollar hegemony has been the USG's biggest disincentive to maintain fiscal and monetary discipline. The dollar's dominance has done the U.S. a huge disservice as it struggles to maintain its fiscal and monetary discipline, and has facilitated a vicious cycle of twin trade and fiscal deficits, coinciding with a weak dollar policy by the Federal Reserve. We can see clearly the self-destructive nature of this path.

The fact that the dollar's hegemony is ultimately controlled by foreign entities has rendered the U.S. Federal Reserve increasingly ineffective as a domestic central bank. As Zero Hedge's research notes (through the Fed's Bloomberg FOIA release), the majority of the dollars generated by QE2 were funneled to foreign banks (especially European banks) instead of U.S. banks. Among the 20 Primary Dealers currently recognized by the New York Fed, 12 are foreign. The Eurodollar market -- which accounted for nearly 90 percent of all international loans by 1997 -- enables a skewing of reserve balances towards foreign banks operating in the U.S.

Foreign banks operating in the U.S. often lend reserves to home offices or other banks operating outside the U.S., and do not comprise a large percentage of consumer or real estate loans. Foreign banks represent about 16 percent of commercial bank assets and only about 9 percent of bank credit, adding far less value to the average American than domestic banks -- yet obtaining a disproportionate amount of assistance -- directly or indirectly -- from the USG. Thus, the notion that excess reserves enhance lending activities and money growth is greatly diminished by the skewing of excess reserve balances toward foreign banks. The truth is, cash assets held by foreign banks operating in the U.S. grew more than six times between the fourth quarter of 2008 and the third quarter of 2010, and have more than tripled again this year.

Regarding the mystery of why U.S. bank lending remains stagnant even though the Fed has pumped so much money into the system, Stone McCarthy's research notes that affiliated foreign branches of U.S. banks tend to borrow dollars in the Eurodollar market. Given that a Eurodollar is nothing more than a dollar denominated deposit at a bank outside the U.S., the bank holding the Eurodollar deposit will ultimately have a dollar denominated claim against a bank domiciled in the US. That U.S. bank in turn holds reserve balances at their local Federal Reserve banks, so when Eurodollar deposits move from one foreign bank to another, the claim against the original U.S. bank follows the Eurodollar deposit.

If a bank domiciled in the U.S. borrows dollars from a bank outside the U.S., effectively what happens is that the reserve balance of the U.S. bank underpinning the Eurodollar account is reduced, and the reserve account of the borrowing bank in the U.S. is increased. Overall, U.S. bank reserves are left unchanged, but the distribution of those reserves is changed from one bank in the U.S. to another, possibly even from the books of one Federal Reserve Bank to another. There was a $630 billion increase in foreign bank cash balances in the U.S. between November 2010 and May 2011 -- which coincides neatly with the date when the Fed commenced QE2. During the same period, Fed reserves saw a $610 billion increase.

By comparison, how did cash held by U.S. banks fare as a result of QE2? Not well. Cash balances at small and large U.S. domestic banks did not increase to the same extent as cash at foreign banks; as was the case with QE1, most of the dollars created by QE2 went to foreign banks. This is the curse of the dollar as the world reserve currency. With the powerful Eurodollar market and near-zero domestic interest rates, the Federal Reserve has become a rather impotent domestic central bank as the recovering U.S. economy continues to struggle in a liquidity trap and the dollar chases yield elsewhere.

The dollar's hegemony has become increasingly fiscally and monetarily unsustainable to the U.S. itself, and will come to an end either by a forceful market correction or a gradual reconstruction of global reserve currency system. The best candidate for such a reconstruction was previously the Euro. It is of course possible that Europe will survive its current sovereign debt crisis, but it is difficult to imagine that the currency of a continent so battered will be strong enough to replace the dollar at the world's reserve currency any time in the near- or medium-term -- though stranger things have happened. For the foreseeable future, the Chinese Yuan also cannot become the world's reserve currency, and can at best continue to act as a regional invoicing currency among trading partners. In the absence of a meaningful alternative, the global currency system will in all likelihood continue to hobble along using the wounded dollar. By default, this means that the emasculation of the dollar will continue unabated, the U.S. Fed will remain ill equipped to perform some of its most basic tasks, and the U.S. banking system will continue to function in a manner that falls well short of the best interests of the average consumer.

Daniel Wagner is CEO of Country Risk Solutions, a political risk consulting firm based in Connecticut (USA), and author of the forthcoming book "Managing Country Risk" (CRC Press, 2012). Dee Woo is a lecturer in economics at the Beijing Royal School.