January 17, 2012
Now an interesting question is why that happened. There are two very big elements to that story. I have argued that one, which is partly linked to the dollar as a reserve currency, was the emergence of the emerging and developing countries as very large capital exporters. This was a very unexpected situation, in that they were net capital exporters, supplying capital to the world from the Asian financial crisis onwards. China was a big part of that.
The second part of that was the form that those capital accumulations took, mainly the desire for safe assets, particularly US Treasuries, which created extremely easy conditions for the supply of those reserve assets.
There was very low inflation in the world for a whole set of reasons. You had this huge aggregate net supply of capital – the so-called savings surplus, which is a correct description of part of what was happening – that created conditions in which central banks, particularly the Fed but also the ECB, could pursue extremely relaxed monetary policy, particularly in the early 2000s.
The two together – low real interest rates from the savings surplus and low nominal short rates because of central bank policy – created the conditions for this huge credit boom, which was not just unique to the US. You saw it in the UK, Spain and Ireland. It buoyed up also the exporting countries – Germany, the Netherlands, Japan and China of course. So that's the story of how we got here. I wrote a book about that aspect of the story.
The fact that people were very happy to buy US assets as reserves was obviously a part of that story. It would've been an interestingly different and complicated story if that hadn't happened. I've argued that, with the rest of the world wanting to buy US assets, which pushed up the real exchange rate of the dollar and weakened the external competitiveness of the US, it was inevitable that Fed policy would generate demand predominantly in the non-tradable sector. It did that, in construction and all the rest of it, and that created the conditions for the financial boom.
Now, if we look to the future, we don't want to do this again, right? So logically, that means that these extraordinary global imbalances which are part of the story need to reverse. It's fairly easy if you look at the US, and also the weaker countries in Europe, to say that in order to balance their economies again, they need a large improvement in net exports to eliminate deficits and move into surplus. That will allow higher savings in the private sector and reduce their fiscal deficits. Instead of having a situation in which the higher savings of the private sector in the US are completely offset by the reduced savings of the public sector, you actually would accumulate assets. But the developing world is resisting.
Now it's very important to get this story correct. I don't believe – and this is crucial – that the dollar as a reserve asset in this story emerges simply from the choices all these countries make. Those choices were made for very good reason and there is no alternative to those choices and I will come to that in a moment.
But the surplus countries are really in the driver’s seat here. The surplus countries are creating the trade imbalances.
Yes, it's predominantly the emerging countries. It's the Chinas and so forth. Those countries want to accumulate claims on the rest of the world, and the claim they want is the safe asset, and the safe asset by agreement is US government liabilities.
The US doesn't have much capacity to deal with this as long as those surplus countries target their exchange rate and are willing to buy these reserve assets, which they clearly are. The reserve position is a byproduct of people's desire to hold assets that are considered to be perfectly liquid and safe, which are US liabilities. That is going to continue for some time, but not forever. There will be a point at which that changes, but I don't expect that to be the next 10 years.
If it is going to change, it will change – this is really crucial – for one of two reasons. Either there is some competitor currency. It doesn't look like the euro at the moment, so it would have to be the renminbi.
But no one wants to be the reserve currency. It’s a curse, right?
Yes, exactly. It's a curse and benefit. It allows higher standards of living, but it a curse. There needs to be a competitor. The other alternative of course is that they decide – and that I think is possible – that they've got enough reserves. Reserves have increased in the world as a whole from $1.6 trillion equivalent immediately after the Asian financial crisis to $10 trillion today. So you have to ask yourself how much is enough? These are very low-yielding assets; in real terms they are negative for most the holders. So it is possible that, even if they don't switch to another reserve currency, that holders of US assets will say to themselves, “We've got enough of this stuff. It doesn't make any sense.”
The demand coming from the US consumer is no longer something you can rely on. Basically, consumption growth is going to be weak from the US. We certainly can't rely on the Eurozone consumer, so actually we are going to have to accept the elimination of our surpluses. We'll have to invest our money abroad. The reserves will stabilize again, as they did for a very long time. The US dollar has been the reserve asset since the 1930s. But it was only in the 2000s that we had this explosive increase in the foreign currency reserve positions. But it's not a permanent consequence.
So it is possible that the dilemma will disappear even if there is no alternative simply because people will say, “That's enough US Treasuries, thank you.” But at the moment, when we are in a position of such panic in the world and people are so nervous, there is a very strong demand by everybody for what is regarded as the least unsafe liquid asset. There has been a run into US Treasuries, not away from them, because of the panic.
But if you are an optimist in the medium to long term, as I am, you say confidence will return. Ultimately we will get through this. People will start wanting riskier assets. They won't want to accumulate more safe US Treasuries, because they really yield very little, and if long-term rates start rising US Treasuries are going to be a terrible investment.
If you look at US Treasuries now, you have to say the downside looks more persuasive than the upside.
Could the special drawing right (SDR) emerge as a viable reserve currency?
We will never agree on the SDR. There is no mechanism because it's not the currency of a state. It doesn't have the guarantee of a state. It's even worse than the euro. In the end, US liabilities are backed by the US economy and the US taxpayer, and people know that is a real entity that will survive. People think that in the end the US fiscal problems will be resolved. Ultimately they are optimistic that the US will solve its problems. That gives some real backing to those assets, which doesn’t exist in the case of the SDR. It's just a political fiction.
If this is going to be resolved, it won't be by some great big “let's have a new world currency” movement. It won't be resolved by the replacement of the dollar by the renminbi. It will simply be resolved by normal economic processes, in which people say that they own enough dollar assets. We've got to where we don't want to continue to rely on the US consumer because the US consumer is not going to come back. That will become more and more obvious. The adjustment will slowly and painfully occur over the next decade.
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