November 5, 2013

The Fed is bungling world’s reserve currency

Posted in Federal Reserve, Finance, Uncategorized tagged at 9:38 PM by Robert Barone

The Fed has proven to be a terrible caretaker of the responsibilities that come with reserve currency status, even while the U.S. economy benefits greatly from it. The bungling is so great that the dollar is now at risk of the loss of that status, and with it, those huge benefits.

Some history

After both world wars, the U.S. had the strongest economy. And despite FDR’s removal of the U.S. from the gold standard in 1933, the Bretton Woods agreements of 1944 established a “gold exchange” standard wherein balance of payment deficit nations were to settle up with surplus nations in gold (at $35 per ounce).

Under this system, when gold payment settlements were made, the gold never was physically shipped but simply “moved” in the holding vault to an area designated for the recipient country.

In 1971, Republican President Richard Nixon removed the world from the gold exchange standard when France demanded physical delivery. Since then, the dollar has served as the world’s reserve currency, with “trust” as the only underlying asset.

The perks of reserve status

Most international transactions today occur in dollars, even if none of the transacting parties is American. For example, if Hyundai (South Korea) sells autos to a business in Argentina, the buyer must first convert the Argentina peso to dollars to pay for the autos. Hyundai can either hold the dollars, or convert them to their home currency (Won).

Note that this transaction has little to do with U.S. economic activity. Yet, it means that there has to be a lot of dollars floating around to support worldwide trade.

The reserve currency status and trust in the U.S. dollar has resulted in the U.S. government’s ability to overspend and issue debt because of the demand for dollars in international trade.

On the other hand, when an emerging economy’s government runs a large and systemic deficit, there are serious fiscal consequences. The value of the currency immediately falls, inflation occurs and the markets force up interest rates, thus impacting that economy’s economic growth.

The reserve currency status and the accompanying trust in the currency also have resulted in the investment of excess dollars in the international system back into U.S. Treasury securities, allowing the Treasury to run large deficits without significant consequences for the currency’s value.

Emerging pressures

Of course, we’ve all heard stories that countries like China and Russia have been advocating that the world adopt a different reserve currency. Many dismiss China’s and Russia’s positions as political rants. But these gripes are legitimate, and unless they are changed, the existing monetary and fiscal policies in the U.S. eventually will move the world toward an alternative reserve currency system.

Policy impacts

While Congress has played a major role, the Fed in particular has been irresponsible as the caretaker of the world’s reserve currency. Because the U.S. never openly asked that the dollar be the reserve currency, the Fed maintains that its only interest is in America’s economic performance. But Fed policies, such as quantitative easing, have huge consequences worldwide.

For example, when the Fed tells the capital markets that interest rates will be 0 percent for an “extended period,” as it did in 2012, hedge funds borrow dollars at minuscule yields and send unwanted dollars to higher-yielding emerging market economies.

Those capital movements have been monstrous, often overwhelming the emerging economy’s underdeveloped financial system, causing inflation in the local economy along with rising interest rates and slowing economic growth.

Then, last May, when Fed Chairman Ben Bernanke used the word “taper,” those huge flows, which had built up over a period of months, almost instantaneously reversed as the hedge funds raced to repay their borrowings before interest rates rose further.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.

Call them at 775-284-7778.

Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

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