…The Fed was responding to complaints from dealers of a shortage of Treasurys in the interbank markets, but without recognizing that the root cause was the flight from the dollar in the foreign exchanges. …Stabilizing the dollar in the foreign exchanges and encouraging the return of flight capital to the U.S. will require two things. The first is to convince the U.S. Federal Reserve that continually cutting interest rates and expanding the U.S. monetary base is not the appropriate response to today’s credit crunch; rather it triggers a vicious cycle.
Prof. Ronald McKinnon asserts that the Fed is engaged in a positive feedback loop:
-credit crunch -> Fed cut’s rates -> capital flight -> dollar falls ->
-> foreign central banks buy Treasurys to block appreciation of their currency ->
-> exacerbates the credit crunch [loop the cycle]
If he is correct, then “we have a problem Houston” until the Fed breaks the loop.
I note that McKinnon is a professor at Stanford University and a senior fellow at the Stanford Institution for Economic Policy Research. His impressive CV doesn’t guarantee that he is correct — but his credentials in international economics and exchange rates are rather impressive. He is the author of at least three relevant books:
- Money in International Exchange: The Convertible Currency System (1979),
- The Rules of the Game: International Money and Exchange Rates (1996),
- Dollar and Yen: Resolving Economic Conflict between the United States and Japan (1997)
Economists have failed rather dismally to construct convincing theoretical models of why the seemingly endless U.S. current account deficits are sustained by a seemingly endless willingness of the rest of the world to acquire dollar assets. Reflecting this conceptual inadequacy, many see the continuation such of global “imbalances” to be unsustainable because foreigners—both governments and their private sectors—will eventually cease buying dollar assets, which will trigger a collapse in the dollar’s value in the foreign exchanges. Beginning with the infamous twin deficits of the Reagan presidency in the 1980s, such failed predictions have been commonplace for more than 20 years.
Throughout Asia, the Americas, and much of Africa, the dollar remains the dominant money as a vehicle for clearing international payments between banks, as a unit of account for international trade in goods and services, and as a reserve cum intervention currency for governments. True, the euro has become by far the most important regional currency spanning the smaller economies immediately east of the euro zone. There is a “euro standard” in Eastern Europe. But the euro is not yet important for transacting among non-European countries, whereas the dollar dominates transactions not involving the United States, e.g., when China trades with Malaysia or Brazil or Angola.
This resilience of the world dollar standard makes the dollar definitive international money. Alone among nations, the United States has a virtually unlimited line of credit with the rest of the world to sustain its current account deficits because, in extremis, it could create the necessary international means of payment to repay debts to foreigners. This confounds the prognosticators of the dollar’s imminent collapse because they have seen less highly indebted countries in Asia and Latin America ultimately being forced to repay—often in crisis circumstances. What makes the position of the U.S. dollar, and the borrowing capacity of the American economy, so different?
For McKinnon’s answers you’ll want to read the complete paper — it’s only 14 pages.
In the next section Rising Protectionism in the United States and Conflicted Virtue in Asia, McKinnon examines another of my top concerns, protectionism:
Be that as it may, currently the main threat to the Fed’s ability to commit to stable money is not monetary per se. Rising protectionism in the United States is the major threat to the dollar’s pre-dominance as international money…
Enjoy!
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