Should The World's Reserve Currency Yield Zero Percent

U.S. investors must ask themselves how long the U.S. dollar can remain the world's reserve currency when the Fed is targeting interest rates at zero percent. Following the end of WWll, the United States owned most of the world's gold supply, manufacturing base and war machines. It made sense for countries to desire to peg their currencies to the globe's only super power. However, in little more than half a century, we have moved from the world's largest creditor nation to the world's largest debtor nation. And now after this week's policy change, we have the lowest overnight lending rate of any industrialized country on the planet.

A major consequence of our current $10.6 trillion national debt is that we are beholden to China, Japan and the Euro zone to finance it. In addition to our current debt, we have a government push to stimulate the economy buy exploding annual deficits to over a trillion dollars. One outcome from our effort to repeal the business cycle has been to pull the rug out of the nascent bull market in the U.S. dollar. After making a stunning 22% advance from July to December, recent Fed policy moves have served to crush the dollar down 12% in just three weeks.

Even though all global currencies have adopted a fiat currency system, the U.S. zero interest rate policy makes the Euro zone's target rate of 2.5% and the Bank of England's 2.0% look like hard currencies. More importantly, the evidence of our falling currency will be most evident in the huge reflation trade in hard assets.

But it is not only that the Fed is in the vanguard when it comes to printing money in order to lower Fed Funds and the Discount rate. It is now striving to artificially control many "free market" rates including commercial paper, mortgage backed securities and Treasuries. And it's not only Ben Bernanke's actions that are so egregious; it is also his rhetoric that may cause international investors to take umbrage. The Fed head's statement following the conclusion of the F.O.M.C. meeting contained some frightening clues about the future direction of dollar. He stated that he will stimulate the economy "...through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level." He went on to say that "The committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the Fed Funds rate for some time."

The Law of Unintended Consequences

If the Fed is successful in driving domestic investors out of Treasuries and into assets such as stocks and real estate, what makes them think that international investors won't do the same? However, if foreign investors curtail their purchases of treasuries, the Fed may be forced to be the buyer of last resort. Printing money to purchase a nation's debt is the formula for wrecking a currency and creating intractable inflation. Is that really the best strategy to fighting a recession? Tax cuts and spending cuts are the only long term solution. We must grow the economy by empowering the private sector. I would have hoped by now we learned that inflation doesn't solve anything.

Comments

[Sundialsvc4]

It's called "printing money." And we need only look at the Wiemar Republic days of mid-war Germany to know what happens.

The only sensible thing that an international businessman can reasonably do now is to insist upon being paid in a currency other than the United States Dollar. The existing treaty that ties Oil transactions to the Dollar must be rescinded, even though Henry Kissinger somehow isn't dead yet.

The scheme adopted by the European Union will quickly be adopted by other countries, in recognition of the now-obvious fact, if the currency used for trade by many countries can be adversely affected by the policies of just one, all of them will pay the price.

"If you're going to trade with Europe, you have to do so using Euros. If you're going to trade with any country from Mexico southward, you must do so using (heh) South-os. Any of your favorite Far East suppliers will require payment in (say) East-os. You're likewise free to demand that you must be paid in Dollars for the stuff that YOU make ... but, ahem, that means that YOU must "make something," which at the moment you are not doing."

Sounds sensible to me.

[Calliope2008]

2of2: The USD is the only asset that has done well in this crisis. The problem with the USD is that it is NOT FAIR. If the FED manipulates the dollar to rescue failed US interests it will be at the expense of foreign holders of US Dollars. That is the only problem that threatens the dollar. All this talk of reflation only hurts the savers; most of which are outside the US. The problem is that if the USD is "Gold" in this scenario, then only the FED has the ability to make gold whenever it wants. Under a gold standard the ability to make gold would similarly debase the value of gold. But with gold there was/is a relatively constant, predictable increase in its supply through mining.
What if the Fed funds rate went to zero, and was fixed there by law? The next problem would be the quantitative easing printing presses which could be set at a fixed, predictable rate of production as a percentage of gross world product. Then the FED would simply administer this regime and the financial markets would adjust to the situation. The world is waiting to see if the US has the guts to deliver a liberal free market world economy or unfairly change the rules to eke out a few more decades of world dominance.

[Calliope2008]

1 of 2:Henry, the first part is right on. That is the problem; "A domestic currency and a world reserve currency cannot co-exist.". But reverting back to sovereign nation states is to take a giant leap backwards [toward a world where world wars can develop as the 'solution' to extreme economic dislocations.] The present calamity is the result of the globalization gold rush that began in the 80"s. There was an enormous "discovery" of underutilized cheap labor [BRIC economies, etc]. It is an economic shock like the opening the Suez Canal where instantly the world is smaller, inventories can be less because shipping is drastically reduced, etc. The labor arbitrage is still underway. The enormous profits had to go somewhere and all that money has inflated all western assets.The only solution is a new world currency regime. I think it is already largely in place; the USD. The original Bretton Woods arrangement presented the USD as 'good as gold' [since it was convertible to gold]. We are no longer on any kind of gold standard but in many ways the dollar regime is like a gold standard, only better [for the US] and worse [for the rest of the world]. Oil is priced in Dollars [there"s your commodity backing], all world central banks hold USD to defend their own currencies. This is similar to gold movements during a gold standard. The FED has also supported these central banks in this crisis.

[Sundialsvc4]

Even if you create a Suez Canal which dramatically cuts shipping costs, I believe that you nevertheless cannot and must not eliminate YOUR OWN productive capacity.

I think that this is where we made our critical (and recoverable) mistake: even though "BRIC nations" might be able to "sell for less," you cannot ... ahem ... emasculate your own productive capacity in the process of taking advantage of good prices. You must remain strong, retain your phalanx of factories and of the factories that surround them, and continue to support them. Thus, BECAUSE you remain strong, you strengthen the nations with whom you choose to trade.

America's present trading position is openly parasitic, and no sensible businessman elsewhere on the planet will continue to put up with it. If the situation were reversed, "nor would we." This is fundamentally wrong, and it's our job to fix our own mess.

[Calliope2008]

I agree that America's trading position is not sustainable, hence the crisis unfolding now. But all the major economies had a part in this outcome. It seems to me that given time the living standards of the world will balance if the "correction" that is underway does not kill the global financial market patient first. The world has never been so productively linked. The international institutions that exist, including the Dollar regime must be made to work FAIRLY for the good of the global market. Scrapping them and staring over would be much more difficult and painful. If the 'creditor' world is holding US dollars that have yet to be redeemed for USD assets, then it is in their interest for the USD to be as strong as possible, so it will buy the most assets. Is it reasonable to suggest that USD assets [US real estate, shares of COKE, etc] are worthless compared to their foreign counterparts? That is what a flight from the dollar would confirm. Conversely, The US debtor desires a weak dollar since that will relieve their debt burden. My point in all of this is if the Dollar regime was fair [ie not exclusively under America"s control], the world financial system would be stabilized.

The French said it best: "Nous sommes tous Américains".

[haljett]

Great article. I think the history you bring out about the US after WWII and the amount of gold reserves we had and the industries we had is seminal. Do you know who has the biggest gold reserves right now? I hear a number of people saying that their may be a shift to China as the world's reserve currency. I don't particularly like that idea out of pure ideology on freedoms.

But I know that the current state of the US debt has a lot of us scarred and it seems like the dollar is on the teetering point to oblivion which I think is why as I watch in real time this morning the price of gold I think that people are looking to put some of their monies into the shiny yellow metal. People like Peter Schiff are saying that it's only going to go up from here and the US economy is going to tank. Not something that I like to hear but something that probably should be listened to as he called the whole down turn.

[Michael Pento - Huffpost Blogger]

I as well called the whole downturn as early as June of 2005. The dollar will lose value against our major trading currencies but the decline will be especially evident against hard assets.
China will most likely be the world's next super power and reserve currency. I believe precious metals will play a big role in addition.

[Sundialsvc4]

I believe that we will see the notion of " 'a' reserve currency" go by the wayside. If any one nation controls the "reserve currency," it can and will exploit that position to the detriment of all others.

Instead, I believe that you will see more "trading unions," such as the European Union. No single member of that Union is able to "do as they please," and this is by-design. I think that they have amply shown that (although it has its inevitable share of problems) this design works.

[DuganS1]

The housing downturn was called repeatedly from 2003 thru 2005. The idea that China will have the next world reserve currency is laughable. They barely have a functional financial services sector. As recently as this decade a large number of their banks were effectively insolvent as China has a long historic record of boom and bust cycles and banks are rarely able to write-off the bad loans and replace them with new capital (without the govt) as they are here. China having large gold reserves is almost meaningless. Gold could easily go down to 2001-2002 lows if deflation continues and people realize they not only get no yield but have to pay storage costs by holding the gold.

[Henry]

A domestic currency and a world reserve currency cannot co-exist. We are observing the reasons for this. Reality will either revert back to sovereign nation states with varying degrees of protection or there will be a global economy with a single global currency. I do not think the world is quite ready for the latter so I'd thing we'll lick our wounds and revert back to the former.

[Sundialsvc4]

Uh huh. Human nature ... :-D ... we really are all greedy sots, given half a chance, eh? ;-)

"Have fun at the bar, but don't buy another man his drinks."