Friday, November 28, 2008
"Why are investors rushing to purchase US government securities when the US is the epicentre of the financial crisis? This column attributes the paradox to key emerging market economies' exchange practices, which require reserves most often invested in US government securities. America's exorbitant privilege comes with a cost and a responsibility that US policy makers should bear in mind as they handle the crisis. ... But there has been a prominent exception to this classic tale. With fitting irony, the US, which is the epicentre of the crisis has avoided Act Three. [Here governments pick up the pieces, typically passing on the cost to future generations by issuing a vast volume of debt]. ... If this had happened to any other government in the world whose national financial institutions were in as deep disarray as those of the US, investors would have run for the hills--cutting off the offending nation from global capital markets. But for the US, just the opposite has happened. ... But why do global investors rush into a burning building at the first sign of smoke? ... The dollar portion of [official foreign exchange] reserves is most often invested in US government securities, which offers excellent market liquidity, and US government debt is also considered as safe as anything. ... The last time foreign official purchases bulked so large in the US government's financing was from 1968 to 1973, when the Bretton Woods system of managed exchange rates broke down. ... This time around, the source of [system] support has shifted to Asian-Pacific economies and Middle East exporters. In both cases, the message from the US seems best summarised in the words of then-Treasury-Secretary John Connolly, who famously said, 'the dollar is our currency, but your problem.' ... US officials must recognize that their nation's funding advantage rests on the unrivalled, for now, position of US government securities in global financial markets. ... Open access to markets probably allowed US government officials to drift in their response to the financial crisis. They initially mistook a solvency problem for a liquidity one. ... As for responsibility, officials must recognize that investors have granted the US its reserve-currency staus for reasons. Size matters, but other reasons include a respect for law and for contract enforcement and the predictability and transparency if the policy process", my emphasis, Carmen & Vincent Reinhart (C&VR), 17 November 2008 at http://voxeu.org/index.php?q=node/2658.
This article returned me to 1966 with Charles De Gaulle's criticisms of the dollar. I saw this act then, but now China, Japan and India have taken France and Germany's 1966 role, holding overvalued dollars they need "do something" with. Emerging market economies hold dollars to suppress their exchange rates, in effect, engaging in mercantilism. Global investors are hypnotized by dollars. I wrote of the Russians panicking into the dollar on 6 November 2008. I remember when Connolly said the statement quoted by C&VR. "US government officials ... initially mistook a solvency problem for a liquidity one". Really? I don't believe even Henry Paulson (HP) is that dumb. I think HP lied. A "respect for law"? In the US? I think the Bush administration has contempt for law, see my 9 November 2008 post as an example. Look at the bailout. I agree with most of what C&VR wrote here, but think the authors are naive. Unlike France in 1966, I think China will pull the plug on the dollar, sooner or later.