24 August 2011

How the Dollar Hegemony Fuels the US Twin Deficit and Produces an Ineffective Federal Reserve

Global trade and financial structures are intertwined and dependent on each other for sustenance. If (when) the US economy collapses in a big way, those countries that have not learned and cut their ties will fall with us. Maintaining our present full speed ahead mentality, knowing there will be an abrupt crash, is suicidal for our economy. Those that continue to attempt to manipulate the public into thinking everything will be okay are simply looting our nation as long as they are allowed to. The only way to survive as a nation is to kill our fiat currency before it kills us and go back to a gold standard that can not be manipulated and controlled by a power-hungry government. 

Hold on, this is a long one.

All good things come to an end

The recent US debt crisis and ensuing S&P downgrade has brought the whole world to a standstill. The scariest part is nobody knows how to react to a possible US default. The whole world has taken the US's solvency for granted for way too long. The booming global trade has been so heavily collateralized against the US deficit that we really don't know how it's going to function otherwise. World trade is now a game in which the US produces dollars and the rest of the world produces things that dollars can buy. All the central banks need to accumulate dollars to sustain their undervalued currency and comparative advantage in trade. So what happens if the federal government goes bankrupted and the dollars become worthless?

This is really a wake up call to all. The world needs to decouple its well being from the US deficit. We can't delay the inevitable for ever, or else next time it will be more than just a close call.

We need to be prepared for a world without the dollar as the dominant reserve currency and global vehicle currency, and without the US consumption economy as the vital export growth engine. We need Euro to step up and take more responsibilities over from the dollar, we need China to unleash a consumption economy to help solve the grievous global imbalance. Otherwise the world economy will continue functioning by inertia until the dollar and the US consumption economy can't support the weight placed on them no more.

The world has prospered on the debt-fueled credit binge in the US for decades. All good things come to an end.

 


As to how the dollars from QE2 went to foreign banks operating in the US, Stone McCarthy's research notes:Effectively the affiliated foreign branch of a US bank (whether a domestic or foreign institution) would borrow dollars in the Eurodollar market. A Eurodollar is nothing more than a dollar denominated deposit at a bank outside the US. The bank holding the Eurodollar deposit will ultimately have a dollar denominated claim against a bank domiciled in the US. That US bank in turn holds reserve balances at their local Federal Reserve Banks.

Below are the chart of the total cash holdings of Foreign-related banks in the US using weekly H.8 data.


The $630 billion increase in foreign bank cash balances since November 3, which just so happens to be the date when the Fed commenced QE2 operations in the form of adding excess reserves to the liability side of its balance sheet. Here is the change in Fed reserves during QE2 (from the Fed's H.4.1 statement, ending with the week of June 1).


Above, note that Fed reserves increased by $610 billion for the duration of QE2 through the week ending June 1 (and by another $70 billion in the week ending June 8, although since we only have bank cash data through June 1, we use the former number, although we are certain that the bulk of this incremental cash once again went to foreign financial institutions).


This is the curse of the dollar as the world reserve currency. With the powerful Eurodollar market and near-zero domestic interest rates, the federal reserve has become a rather impotent domestic central bank while the recovering US economy is struggling in a liquidity trap and dollar chases yield else where.
The dollar hegemony has become increasingly fiscally and monetarily unsustainable to the US itself. The dollar hegemony will come to an end by either a forceful market correction or a knowingly gradual reconstruction of global reserve currency system. The best candidate in this reconstruction is Euro. RMB has no way joined in the race to be a world reserve currency in a foreseeable future and at best it can act as a regional invoicing currency among trading partners, because China has some insurmountable flaws when it comes to the candidacy of a world reserve currency:a political structure sharing no aspiration with the democratic economies, powerful state control on the economic issues, over-manipulated exchange rate, impotent law system to protect property rights, and fragile diplomatic relationships with many trading partners. Let's pray Europe will survive the current sovereign debt crisis so that Euro will one day be strong enough to share the decisive responsibility as the world reserve currency along with the US dollar.

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