Dollars for Dummies

This past week, Glenn Beck spoke about the impending danger of the dollar being dumped by the world market. He said we were smart enough to understand what that meant. Unfortunately, he underestimated the average Conservative American’s financial literacy. That’s not to say that no one understand what “dumping the dollar means;” it’s just that those who haven’t taken a college course in economics or were born after 1960 or so probably don’t.

Dr. Barry Einchengreen, a professor of economics and political science (!) at the University of California, Berkeley (!) did and got busy on his computer to explain to the average consumer, as best as a doctorate professor can. His column was published in the March 2, 2011, edition of the Wall Street Journal.

He sounds like something of a cheerleader for this demise of the dollar. Nevertheless, he at least explains what’s happening and why in a fairly coherent fashion. Some of his terminology, such a “derivatives,” still needs translation. But once you understand the lingo, you understand what’s going on.

“The single-most astonishing fact about foreign exchange,” he begins, “is not the high volume of transactions, as incredible as that growth has been. Nor is it the volatility [the extreme ups and downs and the risks that are inherent for loss], as wild as the markets are these days. Instead, it’s the extent to which the market remains U.S. dollar-centric.”

So what the heck are this economics professor and Glenn Beck talking about. We thought only Americans used the American dollar. Why would anyone else want to use it? Well, the American dollar, it turns out, has been a lot like the English, or American-English language. Prof. Eichengreen gives an example.

“When a South Korean wine wholesaler wants to import Chilean cabernet, the Korean importer buys U.S. dollars [the professor, in his article, put the wrong word in italics to for general understanding], not pesos, with which to pay the Chilean exporter. Indeed, the dollar is virtually the exclusive vehicle for foreign-exchange interaction between Chile and Korea, despite the fact that less than 20 percent of the merchandise trade of both countries is with the U.S.”

The reason for that, Eichengreen goes on to explain is that, “[F]ully 85 percent of foreign-exchange transactions world-wide are trades of other currencies for U.S. dollars. What’s more, what is true of foreign-exchange transactions is true of other international business. OPEC sets the price of oil in dollars. The dollar is the currency of half of all international debt securities [translation: bank notes, bonds, and debentures (bonds secured by the general credit of the issuer rather than the value of the asset)]. More than 60 percent of the foreign reserves of central banks and governments are in U.S. dollars.

“The greenback, in other words, is not just America’s currency. It’s the world’s.”

But Eichengreen believes, as does Glenn Beck, that that “reign is coming to an end. …In the next 10 years, we’re going to see a profound shift toward a world in which several currencies compete for dominance. The impact of such a shift,” he writes will have “implications for, among other things, the stability of exchange rates, the stability of financial markets, the ease with which the U.S. will be able to finance budget and current-account deficits [short translation: imports vs. exports], and whether the Fed can follow a policy of benign neglect toward the dollar.

“How,” he asks, “could the dollar’s long-time most-favored-currency status be in jeopardy? To understand the dollar’s future,” he writes, we must “understand [its] past.”

“First, its allure reflects the singular depth of markets in dollar-denominated debt securities. The sheer scale of those markets allows dealers to offer low-bid ask-spreads [the amount by which the asking price exceeds the bidding price]. The availability of derivative instruments [an agreement for an exchange based on the expected future price movements of the underlying asset, the asset to which it is linked, e.g., a share or currency] with which to hedge [protect] dollar exchange-rate risk is unsurpassed. This makes the dollar the most convenient currency in which to do business for corporations, central banks, and governments, alike.

Got that, so far? No wonder economists use such big, billion-dollar words. The definitions are even bigger. Prof. Eichengreen goes on to the second reason for the popularity of the U.S. dollar.

“The dollar,” he explains, “is the world’s safe haven. In crises, investors instinctively flock to it, as they did following the 2008 Lehman Brothers failure. This tendency reflects the exceptional liquidity [the ability to settle or pay back the debt quickly and easily] of markets in dollar instruments, liquidity being the most precious of all commodities in a crisis. It is a product of the fact that U.S. Treasury securities, the single most important asset bought and sold by international investors, have long had a reputation for stability.”

In other words, investors get their dollar’s worth – the dollar held its value, as opposed to say, your 2001 Dodge Minivan.

“Finally,” the professor tells us, “the dollar benefits from a dearth [a lack] of alternatives [that is to say, competition]. Other countries that have long enjoyed a reputation for stability, such as Switzerland, or that have recently acquired one, like Australia, are too small for their currencies to account for more than a tiny fraction of international financial transactions. [They don’t do enough international business and don’t have enough printed money to make it worthwhile].”

The world is catching up with us, though, Prof. Eichengreen chortles. “The three pillars supporting the dollar’s international dominance are eroding.”

The first change he cites is technology. Traders can now compare currency prices in an instant and can quote prices in other currencies without “confusing their customers.”  Now that there is room – and the technology – for more than one international currency, just as there is room for more than one operating system in personal computers, he says, “[T]he dollar is about to have real rivals in the international sphere for the first time in 50 years.”

He names two viable alternatives – the Euro and the Chinese Yuan, but thanks to the International Monetary Fund (IMF) which created the SDR in 1969 to supplement its member countries’ official reserves, there are also the Japanese Yen and the English Pound Sterling (England having refused to link its currency to the Euro).

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation that took effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs increased from SDR 21.4 billion to SDR 204 billion (equivalent to about $308 billion, converted using the rate of August 31, 2010).

The SDR was created by the IMF to support the Bretton Woods fixed exchange rate system, a system of monetary management that established rules for commercial and financial relations among the world's major industrial states in the mid 20th century. During World War II, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in Bretton Woods, N.H., for the United Nations Monetary and Financial Conference. They were preparing to rebuild the international economic system even as World War II raged on. The delegates deliberated upon and signed the Bretton Woods Agreements during the first three weeks of July 1944.

Setting up a system of rules, institutions, and procedures to regulate the international monetary system, the planners at Bretton Woods established the IMF and the International Bank for Reconstruction and Development (IBRD), which today is part of the World Bank Group. These organizations became operational in 1945 after a sufficient number of countries ratified the agreement.

The chief features of the Bretton Woods system were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the U.S. dollar and the ability of the IMF to bridge temporary imbalances of payments.

On Aug. 15, 1971, the United States unilaterally terminated convertibility of the dollar to gold. As a result, the Bretton Woods system officially ended and the dollar officially became “fiat currency,” backed by nothing but the promise of the federal government.”   In other words, Nixon took the U.S. off what was known as “The Gold Standard.” This action, referred to as the Nixon shock, created the situation in which the United States dollar became the sole backing of currencies and a reserve currency for the member states.

The Bretton Woods system was the first example of a fully-negotiated monetary order intended to govern monetary relations among independent nation-states. A country participating in this system needed official reserves - government or central bank holdings of gold and widely accepted foreign currencies - that could be used to purchase the domestic currency in foreign exchange markets, as required to maintain its exchange rate. But the international supply of two key reserve assets - gold and the U.S. dollar -proved inadequate for supporting the expansion of world trade and financial development that was taking place. Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF.

However, only a few years later, the Bretton Woods system collapsed and the major currencies shifted to a floating exchange rate regime. In addition, the growth in international capital markets facilitated borrowing by credit-worthy governments. Both of these developments lessened the need for SDRs.

The SDR is neither a currency, nor a claim on the IMF. Rather, it is a potential claim on the freely usable currencies of IMF members. Holders of SDRs can obtain these currencies in exchange for their SDRs in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the IMF designating members with strong external positions to purchase SDRs from members with weak external positions. In addition to its role as a supplementary reserve asset, the SDR, serves as the unit of account of the IMF and some other international organizations.

The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold -which, at the time, was also equivalent to one U.S. dollar. After the collapse of the Bretton Woods system in 1973, however, the SDR was redefined as a basket of currencies, today consisting of the euro, Japanese yen, pound sterling, and U.S. dollar. The U.S. dollar-equivalent of the SDR is posted daily on the IMF’s website. It is calculated as the sum of specific amounts of the four basket currencies valued in U.S. dollars, on the basis of exchange rates quoted at noon each day in the London market.

The basket composition is reviewed every five years by the Executive Board to ensure that it reflects the relative importance of currencies in the world's trading and financial systems. In the most recent review (in November 2010), the weights of the currencies in the SDR basket were revised based on the value of the exports of goods and services and the amount of reserves denominated in the respective currencies that were held by other members of the IMF. These changes become effective on January 1, 2011. The next review will take place by 2015.

Prof. Eichengreen predicts, that despite media reports and other economic predictions, that the Euro will remain stable. European governments “will proceed with long-term deficit reduction, something about which they have shown more resolve than the U.S. And they will issue ‘e-bonds’ – bonds backed by the full faith and credit of Euro-area governments as a group – as a step in solving the crisis. This will lay the groundwork for the kind of integrated European bond market needed to create an alternative to U.S. Treasurys [sic] as a form in which to hold central bank reserves.”

I’m not an economist, but this prediction seems rather optimistic on the part of the professor, given that some European countries have gone into default. But hey, I’m an English-Communications major, not an Economics major.

He continues, “China, meanwhile, is moving rapidly to internationalize the yuan. The last year has seen a quadrupling of the share of bank deposits in Hong Kong denominated in yuan.” The professor cites 70,000 Chinese companies doing international business in yuan, along with dozens of foreign companies. “In January, the Bank of China began offering yuan-deposit accounts in New York insured by the Federal Deposit Insurance Corp.”

This, the professor tells us, frees them from engaging in costly foreign-exchange transactions. “They will no longer have to bear the bear the exchange-rate risk,” Eichengreen writes, “created by the fact that their revenues are in dollars, but many of their costs are in yuan. Allowing Chinese banks, for their part, to do international transactions in yuan, will allow them to grab a bigger slice of the financial pie.”

China has a long way to go, he writes, but building liquid markets and making financial instruments attractive to international investors is key to Beijing’s economic strategy.

Eichengreen also fears that the U.S. dollar’s safe-haven status has already been lost due to a lack of security and stability. He fears we no longer have the fiscal capacity to honor our financial obligations and cautions that with “trillion dollar-deficits” stretching into infinity, international investors will question America’s intention to honor its debts or resort to “inflating them away.” That is, by the time we repay the debt, the investor’s money won’t be worth what it was when they invested it. “Foreign investors will be reluctant to put all their eggs in the dollar basket,” he warns.

This change, he says, will make life more difficult – and expensive – for U.S. companies doing international business. They won’t have the convenience of using the same currency to pay workers, import parts, or sell their products to foreign customers, according to Eichengreen. They will have share the same exchange-rate risks and exposures as foreign competitors. But foreign competitors will have the advantage of doing business in their own currencies.

“In this new monetary world, moreover,” writes Eichengreen, “the U.S government will not be able to finance its budget deficits so cheaply [spend money it doesn’t have], since there will no longer be as big an appetite for U.S. Treasury securities on the part of foreign central banks.

“Nor will the U.S. be able to run such large trade and current-account deficits, since financing them will become more expensive. Narrowing the current-account deficit will require exporting more [which the Chinese refuse to buy], which will mean making U.S. goods more competitive on [sic] foreign markets. That, in turn, means that the dollar will have to fall on foreign-exchange markets – helping U.S. exporters and hurting those companies that export to the U.S.”

The professor – and other economists – calculate that the value of the dollar will have to fall by roughly 20 percent [its current value is 66 cents – how much lower does it have to go?]. “Because the prices of imported goods will rise in the U.S., living standards will be reduced by 1.5 percent of GDP - $225 billion in today’s dollars,” Eichengreen explains. “That is the equivalent to a half-year of normal economic growth. While this is not an economic disaster, Americans will definitely feel it in the wallet.”

The good news, Eichengreen tells us is, “the next time the U.S. has a real-estate bubble, we won’t have the Chinese helping is blow it [buying up our debt].”

I’m not sure if I get all of it, and I’m not sure if you do, either, but that, fellow students, is why the dollar is being dumped and why we should be worried about it, as Glenn Beck has been telling us.