Strictly Monetary Part III: The Game of International Reserves

In Financial, Strictly Monetary: A Series on January 30, 2011 at 10:31 AM

Parts one and two covered the essentials about monetary systems and how we control them. But with exponential increases in the speed and amount of international trade, suddenly there is very little separating monetary policy from political games.

Accountants love it when things balance. Every nation in the world has its own balance sheet that can be simplified into two things: The Current Account and the Capital Account.

The Current Account tracks goods and services; it is everything exported minus everything imported. For example, America has had a Current Account deficit for decades, consistently importing more than it has exported. But that means each year it earns less than it spends. How does the USA support this imbalance indefinitely?

That’s where the Capital Account comes in. The government issues debt to other countries and its own citizens, borrowing money in order to sustain its spending habits. Money is borrowed from other nations and injected back into the economy through the banking system, ultimately flowing to businesses and consumers to spend and invest. And there you have it; the balance sheet is balanced. This is not unlike your personal balance sheet. If you consistently spend more than you make, you will accumulate debt to balance your purchases.

How does this work from the perspective of Japan, a significant trade partner and lender to the USA? In order to purchase Sony Playstations, America must buy Japanese Yen in exchange for US Dollars. That leaves Japan with a Current Account surplus in the form of US Dollars.

With those US Dollars, Japan’s central bank proceeds to purchase US Treasury Bonds. This is an asset to Japan, a risk free investment in government bonds denominated in the world’s reserve currency. To America, it is additional debt. But what’s the motivation for this circular monetary flow? Why does Japan, along with other nations, feel compelled to invest in US Government Bonds?

By purchasing US Bonds with the American dollars they receive from exports, the Japanese facilitate trade with any other nation because American Bonds may serve as collateral if Japan wishes to import goods and services from any country in the world. But that alone doesn’t explain why Japan holds so many US Treasury notes. How did Japan end up with such large reserves in US Treasury notes?

Currency Manipulation

Recall that if Japan’s central bank voluntarily converted Yen to purchase US  Treasury notes, this action would push the value of the US Dollar up. It allows Japan to sustain a favourable exchange rate for the Yen, which reinforces exports, thus supporting employment and productivity in the Japanese economy. In fact, in many cases countries have been accused of purposefully hoarding US Bonds to push the exchange rate down and make their goods more affordable. China has been criticized for keeping its exchange rate too low for this exact reason. With a low exchange rate, China is undercutting its global competition because the price of its money has stayed unreasonably low.

The central banks of other nations purposefully stock up on US Notes in order to manipulate the exchange rate in their favour and support their economy. At the end of the day, these countries disregard the value of money altogether and simply focus on making products and services and pushing them to others, securing streams of income from foreigners. All this real economic activity is inspired by keeping  US Bonds in the vault.

Stabilizing Trade For Emerging Countries

Smaller or “emerging” economies are also compelled to stockpile American currency in their central banks, whether they have the desire to trade with America or not. Holding US Treasury notes as reserves helps to stabilize their own domestic currency when the world is not sure whether to trust it in trade.

US Government Bonds have been a trustworthy and widely accepted reserve; they serve to back the strength of emerging currencies in the free market. In other words, other nations trust printed money more if it comes from a nation that has stored a good amount of acceptable reserves in its central bank. This is similar to how you would be more likely to deposit your money in a bank that sets aside a large amount of the deposit in the vault. Ultimately, you are more likely to get your money back because of this practice.

The Dilemma

So America continues to spend while other nations continue to extend the limit on its credit card. Free market economists had traditionally believed that such divergent trade imbalances would correct themselves. After all, what are these countries going to do with all those American dollars? It was thought they would come to their senses and import American goods. Perhaps American goods are not attractive, but instead they might purchase American capital (land, buildings, businesses, and of course, real estate), sparking new investment in the American economy. Indeed, most countries did convert their surplus reserves into long term American real estate investments, such as the now infamous “toxic” Mortgage Bonds.

What is interesting is that China did no such thing. They continued to hoard American Treasury Notes and survived the mortgage collapse relatively unscathed by having minimal exposure to American Mortgage Bonds, ignoring a worldwide trend. So has China outsmarted everyone by doing so?

Not exactly. There are risks to stockpiling the reserve currency. For one, America has printed so much of its own currency that the value of the US Dollar has decreased. The value of money is reflected in what can be purchased with it. That subjects China’s reserves to being worth less. Being the largest holder of American debt in the world, China is hurt the most by America’s inflationary practices.

Which brings us to the current state of the global monetary system. The global demand for reserves has driven America to exorbitant lending in order to facilitate world trade. Today, it’s impossible to find any economist to endorse the idea that the global monetary system will balance itself out through market forces, especially as China’s behaviour has flown in the face of theory every step of the way, and they have emerged as the next economic leader of the world in spite of that.

That’s the beauty of the free market system. Although economists have a hard time explaining why things happen, at the end of the day it is best explained by a gross simplification. China is making stuff and everyone is buying it. Everyone else in the world is supplying China with a strong source of income. Regardless of what happens to money, the price of money, the reserve currency, nothing can change the underlying economic events that are unfolding.

So what does the future of the global monetary system look like if American has risked its reserve currency status through excessive borrowing? This is an indispensable article by The Economist magazine that goes into greater detail on the current state of the system and possible solutions to the problem of this global reserve issue.

Below is an interesting excerpt from the article. While it’s obvious how right Robert Triffin was all along, for the last several decades this dilemma had taken a back seat to the idea that the free market of money exchanges would figure out a way to balance itself out. This wasn’t a conspiracy. It simply demonstrates how unscientific the global monetary system is:

Consider, for instance, the tension between emerging economies’ demand for reserves and their fear that the main reserve currency, the dollar, may lose value—a dilemma first noted in 1947 by Robert Triffin, a Belgian economist. When the world relies on a single reserve currency, Triffin argued, that currency’s home country must issue lots of assets (usually government bonds) to lubricate global commerce and meet the demand for reserves. But the more bonds it issues, the less likely it will be to honour its debts. In the end, the world’s insatiable demand for the “risk-free” reserve asset will make that asset anything but risk-free. As an illustration of the modern thirst for dollars, the IMF reckons that at the current rate of accumulation global reserves would rise from 60% of American GDP today to 200% in 2020 and nearly 700% in 2035.


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