Will QE2 Threaten the Dollar’s Status as Global Reserve Currency

On the eve of President Obama’s arrival to the G20 talks in South Korea, a growing chorus of voices questions the direction of U.S. monetary policy. (Take a look here or here)

Germany’s finance minister, Wolfgang Schaeuble went so far as to scold Chairman Bernanke, saying “With all due respect, U.S. policy is clueless.” (As seen, here)

Some critics (with justification) have argued that America is guilty of the “currency manipulation” policy for which it castigates China. (You can see this, here)

Others have argued that US policies are opening the door to a complete revision of the international monetary system that is based on the dollar. (As seen, here)

World Bank president Robert Zoellick appeared to even suggest a return to some sort of gold standard when he talked of “employing gold as an international reference point of market expectations about inflation, deflation and future currency values”. (See this, here)

I already argued that QE2 is more of a slogan than a policy, and will not repeat those criticisms here. (To see this, click here)

In a new piece at New Deal 2.0, I deal with the two most important issues and misunderstandings surrounding quantitative easing. The first concerns the consequences of injecting another $600 billion of excess reserves into the banking system. The second is associated with Fed attempts to lower long term interest rates through purchases of treasuries. In sum, I argue that QE2 will do no more good than QE1 did because banks already have massive excess reserves and because lower long term rates is not a solution to a situation in which home prices and the markets for goods and services must first turn around before banks will want to lend and households and firms will want to borrow.

Both of these issues are in turn connected to the belief that QE2 will devalue the dollar and threaten its status as the international reserve currency. That is the topic for this column.

With QE2, the Fed will buy $600 billion worth of longer term treasuries (and will “reinvest” another $300 billion of revenues from the previous QE1). The only plausible scenario in which this can prove useful is by “beggaring thy neighbor”. Bernanke has talked openly of his desire to raise inflation expectations, and that in combination with lowering interest rates could make America a less attractive investment option. If so, the dollar could depreciate, increasing US competitiveness in traded goods and services. This could boost exports and depress imports.

At the same time, international managed money would be looking for more attractive investments in strong currencies with higher interest rates—say, the BRICs (Brazil, Russia, India, China)—fueling appreciation of their currencies. In other words, QE2 would do for the US what Geithner claims Chinese currency policy is doing for China—cheapen our exports through a weak currency. No wonder the Chinese are outraged at Secretary Geithner’s finger pointing and accusations of currency manipulation!

At the same time, many developing nations are also facing destabilizing capital inflows, and worry about a reprise of the Asian crisis of the late 1990s when the flows reversed and wrought havoc on their economies. That is why they are threatening to drop the dollar, reduce capital mobility, and move to some sort of fixed exchange rate based on gold or a new international currency.

China has long called for reformation of the international monetary system, preferring movement toward something like J.M. Keynes’s “bancor”—an international currency delinked from any particular country and used for clearing accounts among nations. Meantime, China has moved toward bilateral agreements, using currencies of trading partners rather than going through the dollar. Others have talked about the creation of three or four trading blocks, each using one of the world’s dominant currencies—a dollar area, a euro area, perhaps a pound sterling area, and a yen (or yuan; or won?) area. What I consider to be the nuttier proposals are those that would return to some sort of gold standard.

I do not have here the space to completely address all of these issues, but I will say that while much confusion surrounds the complaints thrown at the US, there is at least an element of truth in the claim that QE2 puts the burden of adjustment onto other nations. The critics are certainly right to argue that so far as domestic policy goes, QE2 does nothing to get the US out of its crisis, and it will work (for the US) only if it depresses the dollar and fuels US exports. But let us examine the arguments for international currency “reform”.

First, gold because that is the easiest. Some have argued that markets are already moving to gold as an alternative “monetary asset”. That is nonsense—gold is not a monetary asset, rather, it is a commodity (of some historical interest because of the two hundred or so year experience on-and-off the gold standard). Gold is currently enjoying a speculative boom (as are many other commodities—much as they did from 2004 to 2008, which was the biggest commodities price boom in human history). That is not too surprising—with the current depression it is hard to find any place to park managed money, and commodities markets are very small relative to the volume of money to invest (except oil and grain), so it does not take much movement into commodities to blow up their prices. Even on the gold standard, gold was never money. Rather, government pegged gold’s price in terms of the domestic currency. It was always a very bad idea. Successful pegging means government has accumulated enough gold to maintain the peg. From the other side, it means government has got enough gold to fend off any speculative attack of those shorting the currency—betting the peg cannot be maintained. Think George Soros. We do not even need to revisit all the economic depressions of the 1800s as well as the 1930s Great Depression to come up with a good argument against tying a nation’s fortunes to the value of gold. That is a subject for gold bugs, Austrians, and other (let us put it delicately) nut jobs.

So what about a “bancor” international currency? Fine. It requires an issuer. It requires international agreements on the conditions under which it is issued. It requires punishment of nations that violate agreements. That sounds like the euro. It is the euro. Who wants to be the next Greece? With no volunteers, let us move on.

The final possibility is division of the world into currency blocks. That is fine and indeed we are close to this already. The problem is that within a currency block, you have got the “regional” currency but between currency blocks you have got to choose the currency of denomination. For the near future, which will extend beyond a time that no one today can contemplate, it will be the dollar. For better or for worse, the dollar will remain the international reserve currency.

I do agree with critics that such a status implies responsibilities—responsibilities that the US has not been living up to. The rest of world needs dollars, especially in a crisis. It obtains those dollars by exporting to the US, and by attracting capital flows. But the US is mired in a deep recession, and it shows no signs of willingness to deal with the financial crisis that makes it impossible for the economy to recover. That is not the behavior that one must expect of the issuer of the international currency. Debasing the currency through policy designed to encourage capital flight or inflation is not appropriate to maintaining the dollar’s status. Critics are right to castigate Washington for short-sighted policy. (See this here)

The best thing that can be done, both for the US as issuer of the dollar and for the rest of the world users of the dollar, is to promote economic recovery in the US. This is not a matter of “affordability”. The US government can “afford” anything for sale in terms of dollars. It is a matter of political will. Can the US overthrow the silly pronouncements of deficit hawks, including today’s statements by the “Fiscal Responsibility” commission, (http://www.fiscalcommission.gov//) to formulate a fiscal stimulus package that will put the US on the road to recovery? If so, the dollar’s problems will disappear. If not, run to gold.

Finally, maintaining the dollar’s international appeal also requires imposition of the rule of law in the US. Currently, the fraud perpetrated by the biggest banks is far worse than anything the Russian kleptocrats and mafia combined could possibly imagine. The US is in the grips of the worst scandals in world history, with the financial sector no longer constrained by anything that would be recognizable as lawful practice. And that is the biggest threat to the dollar as international reserve currency. Unless the top banks are closed, with their management jailed, there really is no hope for the US dollar or for its economy.