Recently, representatives of China and Brazil have suggested that either the Renimbi, the Brazilian Real, or some new currency backed by the IMF be used to substitute the dollar.

US Treasury Secretary Tim Geithner said that this was an idea meriting consideration (but later recanted).

Columbia University economist Jeffrey D. Sachs wrote in the June 2009 “Scientific American” that the Chinese proposal had “much to commend it” and that “Geithner’s first reaction was right”.

Does this mean that the dollar’s role as the global reserve currency is doomed? Can the economists, central bankers, and IMF band together and decree some alternative “world currency”?

Probably not. Here is why.

What importers and exporters want

The main purpose of a global reserve currency is to serve as the means of payment in international trade. The key decisions regarding international trade are not made by central bankers, the IMF, or economists.

The real decision makers are importers and exporters.

Foreign trade is a two-way street: goods flow one way; money flows in the opposite direction.

Both importers and exporters must agree on the goods to be exported and the kind of money to be paid in exchange.

Furthermore, the importer must actually have available the kind of money that the exporter wants in exchange for his goods — this is a key point.

How many importers in the United States or Europe are holding fat balances of Chinese Renimbi or Brazilian Reais in their bank accounts? Not many. Fewer still have balances worth mentioning in Mongolian Togrog or Algerian Dinar.

If it were possible to change the means of international payment by decree to a currency (or basket of currencies) other than the dollar, the immediate result would be a sharp decline in world trade — a depressive effect similar to the tariff wars of the 1930s — simply because not enough importers hold enough of these alternative currencies to sustain world trade.

Governments would fall. It just ain’t goin’ happen!

The shortage of non-dollars

Now I know that some people think that if you need to get some Chinese Renimbi or Brazilian Reais you just go down to the local bank and buy some.

The only unlimited suppliers of Renimbi or Reais are the central banks of China and Brazil. Otherwise, you have to buy these currencies from off-shore residents that have accumulated them as a result of international trade, investment, or tourism.

The problem is that both China and Brazil — and almost every other country in the world except the United States — have a tacit or explicit policy to encourage exports and discourage imports (neo-mercantilism).

Brazil, for example, has an implicit tariff of about 100% on imports.

This means that, other than dollars, most currencies held in foreign hands are in relative short supply.

For the Brazilian Real to become a world trading currency, the government of Brazil would have to remove economic protection from local industries — so that foreign goods would become competitive on the local market.

At the same time, the Brazilian government would have to somehow find a way to convince foreign suppliers to receive payment in Brazilian currency. (if you know how this could be done, please leave a comment on this article.)

The Anti-Gresham’s Law of global currency

Sir Thomas Gresham stated in the time of Tudor England that “Bad money drives out the good”. But this is only true if both currencies are required to be accepted as legal tender at a fixed ratio.

There is no “legal tender” in international trade that binds exporters to accept a certain currency that importers may offer in payment.

Instead, there is a free market in which exporters prefer to be paid in what they perceive as the “best” currency, not the weakest.

Electing the “best” currency

Exporters elect the “best” currency based on their own practical experience, observance of the market, and commonsense:

• In how many other countries will exporters accept a certain currency?
• How safe are bank deposits in the country that issues this currency?

	.

• How well do the laws of the country that issues this currency protect the property rights of foreigners?
• For how many decades has this currency been widely accepted in international commerce?
• Over the last few decades, how well has the central bank of the issuing country protected the value of this currency, compared to other currencies?
• If the exporter (due to problems in his own country) were to move to the country of the other currency, how well would he be received? Would he and his family be comfortable living there? How well does the issuing country receive foreigners?
• How stable is the political and economic system of the issuing country relative to alternatives?

Try to answer each of these question, not in absolute terms, but in terms relative to other currencies — remembering that the currency selected must be issued by a country that is large enough to run a substantial trade deficit to supply enough currency to be relevant in the world economy — without putting the issuing country at risk.

So far, there are only two issuers of currency that even come close to meeting these requirements, the United States and Euroland — and Euroland doesn’t want to run a trade deficit.

How about the International Monetary Fund?

So far, there have been no serious suggestions that the IMF issue legal tender meant to be accepted by exporters throughout the world and that would be widely available in bank checking accounts or by credit card.

Instead, we have various suggestions that only are relevant to dealings between central banks.

An importer can’t pay an exporters in a check issued in SDRs, nor can the exporter uses this “currency” to pay for a trip to Disneyland.

Professor Jeffrey Sachs (in the above-mentioned article) seemed to like the Chinese proposal for “a more symetrical monetary system, in which nations peg their currencies to a representative basket of others rather than the dollar alone”.

However, this would require abandoning the free market, ignoring the “votes” of real-world importers and exporters, and surrendering national sovereignty to a small international body of over-paid, non-elected economists.

Not very likely to happen any time soon.

Too soon to give up on the dollar

The Crash of 2008 was undoubtedly a world-changing event that severely shook the position of the US dollar.

It also brought about the inauguration of one of the least inspiring (in economic terms) governments since Jimmy Carter.

With wild, irrational spending by the Pelosi-Reid Congress combined with quasi-nationalization of the US auto industry and proposals for massive tax increases to fund medical nirvana and a mystical green, “carbon-free” environment — it is not surprising that the Chinese, Brazilians, and other holders of dollar reserves are nervous — but so are a large and growing segment of the US population.

Moreover, US history suggests that the road forward may not be as dismal as it now seems.

1. The US holds Congressional elections every two years, and Presidential elections every four years. President Obama is spending his political capital almost as fast as he is spending taxpayer money. Opposition is growing faster than one would have expected. The genius of American Democracy is the ability to “turn the rascals out”. It seems likely that the Obama administration will become weaker with each passing day.
2. The US financial system will probably emerge from the debacle stronger than ever. Capitalism is all about “creative destruction” and the process is already well underway. Things will be different, but not necessarily worse.

Already there are signs that Americans are saving more, credit card use is being cut, lending to the non-credit-worthy is no longer in fashion, leverage is being reduced, stock buybacks are ending … the system is healing itself.

New leaders will come forward.

We’ll see.

For the last twenty-five years, the Fed flow of funds accounts reveal two dominant forces supporting US stock and bond markets.

• Stocks: Stocks have been driven upwards by corporate executives and mutual fund managers who have backed stock-buybacks/executive option schemes to mutual advantage. As described in the article, “The quarter-century buyback era draws to an end”, this game is over and equities will now have to seek a new course.
• Bonds: The US bond market has been sustained by a huge and ever-growing pool of dollar financial assets held by foreigners as a result of the persistent US trade deficit. For a generation, the trade-deficit/bond market linkage has been a virtuous circle to the mutual advantage of foreign exporters and the US population seeking to spend today, pay tomorrow.

The supremacy of the US dollar is not yet dead, but portents of a fatal cancer — inflation — are there for all to see.

Two myths that make the problem harder to understand

For a long, long time, many people have been seriously concerned about the US trade deficit and about Americans owing vast sums to foreigners. However, by citing the wrong linkages between supply and demand, while forecasting unlikely outcomes, these arguments have clouded, rather than clarified the issue.

The US trade deficit and dollar supremacy does have a definite down side, as we are now seeing, but two persistent myths continue to confuse policy decisions:

1. The “inability to pay” myth: Some suggest that the bill to foreigners will someday come due and the US will not be able to pay the debt, enslaving future generations to debt bondage. See: “Warren Buffett Fears Foreign Ownership”. The problem with this argument is that since the debt is in dollars, the US Treasury can always pay it off by turning the printing press. After inflation, there will be no debt to pay.
2. The “competitive interest rate myth”:Others understand the source of foreign investment in US bonds as being “foreign investors” and “central banks”. This is true enough, and somewhat obvious — the immediate buyers are indeed investors and central banks, but the ultimate source of the money — where it all comes from — are foreign exporters and foreign governments bent on raising domestic employment and keeping local factories busy. It’s not as if there are foreign investors saying, “Oh gee, look at US interest rates compared to rates in Japan. Lets all buy dollars!” No, what happens is that foreigners find themselves holding dollars for one reason or the other and can’t get rid of them by selling to other foreigners. As a group, foreign holders of dollar financial assets only have two options: buy US bonds (or other securities), or buy US non-financial assets (direct investment, real estate, or export goods).

Employment: the cause and downfall of the trade deficit

Governments that hope to survive for long, other than by brute force, are interested in keeping domestic employment as high as possible. The US trade deficit was been sustained for a generation by the fact that it has been good for employment, both in the US and abroad:

• US full employment: Vast sums of ready credit for the US population originating from the trade deficit, has kept employment high. Wall Street and the financial industry has been in a sustained boom for longer than most of those employed there now can remember. Industries such as home building, home appliances, and automobiles have benefited from easy credit. Everyone now has a credit card and it has been easy to buy merchandise imported from China, while keeping millions in the supply chain in business. Barney Frank and Chris Dodd could not have spurred the sub-prime mortgage business without the trade deficit to provide the funds that employed many in building houses that many, otherwise, could not afford.
• Foreign industrialization: While the US has been hell-bent towards becoming a “service economy”, developing countries, including China, have been going the other way towards industrialization. Once you build a factory, you have to keep it busy, or plants will close and workers will be unemployed. This means supporting foreign trade at all cost and not worrying too much about the quality of the foreign currencies being accumulated. It also means adopting a neo-mercantilist attitude, favoring exports over imports.

The fatal flaw in this pretty picture of perpetual employment financed by a growing US trade deficit was the assumption that those employed as financial intermediaries would be responsible fiduciaries, concerned about only lending money to those who were likely to repay. It assumed that bankers knew what they were doing and couldn’t sleep nights unless their customers’ money was safe. It also assumed that financial market regulators were on the side of investors and would be able to stop a Ponzi scheme as vast as that of Bernard Madoff well before even the billion dollar mark was reached.

These assumptions have not only turned out to be false, but to a degree than no one had even imagined or predicted — not even me and I have been really pessimistic about the skills and ethics of financial intermediaries for a long time.

Not only has financial intermediation been broken, but there is a serious doubt as to whether it can be fixed in time to save the dollar.

The unbearable burden of monetary supremacy

Any country that harbors the world reserve currency must take seriously the responsibility to safeguard its financial markets from irresponsible hands. However, the larger the pile of foreign financial assets, the greater the temptation for politicians to use this “easy money” in inappropriate ways.

Barney Frank and Chris Dodd boosted Fannie Mae, Freddie Mac, and sub-prime mortgages for the same reason that Bill Clinton molested Monica Lewinsky: because they could. Without the trade deficit, government sponsored agencies could not have engaged in orgies of stupid sub-prime lending.

The wheels almost came off Citibank in the 1970s when the bank tried to “recycle” petrodollars by lending to third world countries. However, the pile of dollars accumulated in the foreign trade accounts by 2008, was far, far greater than funds from the oil crisis of the Carter years, and Wall Street had grown less cautious and dumber in the interim.

America doesn’t want to be central banker to the world

In order for a country to serve as central banker to the world, the people and the politicians representing them must understand what this involves and be willing to accept the responsibility of keeping the money of the rest of the world safe.

This might be feasible in a small country like Switzerland, but in a nation the size of the United States, such long-term commitment is extremely unlikely.

Americans never voted to defend the US dollar as the world reserve currency. There was never any debate on the issue. No presidential candidate or political party ever put the idea of the dollar being the world’s reserve currency on the platform. Most of the population doesn’t understand the concept or have any idea where money that finances their credit cards comes from.

Dennis Kucinich, a Democrat candidate for president and representative from Ohio, has ranted in Congress that “Banks Are Loaning Our Money To Foreign Countries Instead Of Americans!” Hysteria about foreigners getting there hands on “US taxpayers’ money” is at a high level.

America became central banker to the world by accident. If fact, by mis-managing US finances during President Johnson’s “War of Poverty” and the Vietnam War, inflationary conditions were created that eventually forced President Nixon to abandon the gold-dollar standard, creating conditions for the dollar to become the world reserve currency by default — an unintended consequence on which the American people never had any say or understanding of what this entailed.

Withdrawal from dollar supremacy: will it be painful?

The possible abdication of the US dollar as “world currency” is associated with expectations of inflation and resulting consequences. Among the American electorate, there is no explicit movement either for or against the idea of US acting as the world’s central banker. Most of the population can’t even understand the concept. It simply is not an issue.

President Obama is not President Reagan, stirred by fervent fires of super-patriotism, suggesting US supremacy as the “City on the Hill” and promising “Morning in America”.

Instead, President Obama seems intent on not exercising world leadership, but rather on joining the United Nations and extending the “hand of friendship” to other countries, without pre-conditions. He has picked a Treasury Secretary whose primary world experience is with the International Monetary Fund.

Wall Street itself has “gone international”, with the New York Stock Exchange merging with Euronext, NASDAQ linking up with the OMX Group, and with all major banks active in the international markets. Tears over the demise of General Motors as an “American industry” are found mainly among unionized workers — most people realize that Mercedes Benz is now as “American” as “Ford Motors”.

The primary concern of Congress and the administration is to support domestic employment no matter what this might entail — including substantial risk of wild inflation. If the dollar collapses in the process, so much the better for “US industry”. Except for policy wonks, who don’t carry much weight in the polling booths, no one really cares about the US role as central banker to the world.

So, without political support, the question remains: will the world’s withdrawal from the dollar be painful or orderly.

The demise of the dollar: step by step

The first step in killing the dollar as the world reserve currency is to threaten foreign holders of dollars with inflation that scares their pants off and gets them hunting for safer assets. Obama and the Democrat-controlled Congress have already managed to do this.

The next step is to transfer dollars from foreign hands to US residents, before it is too late. Foreigners can’t get rid of dollars by selling them to other foreigners — they have to trade them with US residents for non-financial assets, like real estate, US companies, or export goods. Since foreigners, as a group, are the only ones with excess dollars to spend in the current depressed economy, and since US residents are hard up for cash, with banks not lending as readily as before, bargains will be available.

The removal of dollars from the accumulated trade deficit pool will suck money out of the US bond market. Interest rates will soar further. With banks de-leveraging, companies will be forced to follow. With a shrinking bond market, the only alternatives are to sell the company to those who still have money (such as holders of financial assets in the trade deficit pool), to raise money by selling stock (in a depressed market), or going out of business. Unemployment will get worse.

The final blow will come when President Obama’s and Speaker Pelosi’s grandiose “spending is stimulus” plans finally come to pass, requiring money from some source. Taxes won’t do, because the country is in deep recession. Cutting government spending is politically unpalatable to those who got elected on promises of such spending. So its up to the monetary authorities to print money and cover the short fall. The end result is inflation at a level Americans have never seen, are unprepared for, and that will devastate the elderly, the poor, and most in between.

By the time the final blow has landed, the world will have come up with some alternative scheme for international currency, probably sponsored by Secretary Geithner’s ex-employer, the International Monetary Fund.

Living in a post-dollar world

In a post-dollar world, Americans will no longer be able to live off the pool of easy money generated by the trade deficit.

In the post-Obama world, now that Americans (those that have managed to stay employed) have paid off mortgages and credit cards with debased currency, there will be renewed interest in sound currency.

However, trips abroad will now be frightfully expensive, as will be imported goods. With American industry having been sent overseas during the years of dollar hegemony, it will indeed be “Morning in America” as brand new, super-efficient factories are built (without labor unions, which have been discredited after the General Motors debacle), and a much, much smaller Wall Street will now be staffed with boring, stuffy bankers, like in the old days, more concerned about depositor’s money and getting repaid than in their own year end bonuses.

Excuse me if I’ve gone a bit too far. It may be time to lie down. I don’t know what is going to happen anymore than you do. These seem to be times of momentous change and it is sometimes useful to try to see what might be coming — so as not to be blind-sided.