Thursday, February 25, 2010

The Coming Currency Firestorm

"Already, the euro is counted as the dollar's dominant challenger, while China's central bank governor, among others, has suggested establishing an alternative (some might say, rival) 'super-sovereign reserve currency.' ... Will we witness a rapid coup (in currency time) occurring over the next ten years, as some commentators believe (see Chin and Frankel, 2008)? Or will we see a much more gradual process owing to the built-in inertia of the dollar's prominent role? ... We report new cross-country evidence of the determinants of substitution to dollar banknotes and find that in developing countries substitution hinges more on historical than an recent experience. ... While there is considerable interest in the determinants of currency substitution--defined as the use of multiple currencies in a given country--there are few established empirical results. The primary reason is that the amount of hard cash in circulation is often unkown. ... Our data come from the [Fed's] international cash distribution operations and include all wholesale shipments of dollars to and from the US between 1990 and 2007. ... We find that the demand for dollars is, above all, about memory. The highest inflation rate recorded over the past 30 years has significant explanatory power in our model--the demand for dollar banknotes goes up for a generation after an inflation shock--while the recent inflation rate has none. ... Assessing the country-level determinants of the use of dollar banknotes may also have important implications for the [Fed's] balance sheet going forward, as the seignorage it earns from currency in circulation is a major source of its revenue", my emphasis, Rebecca Hellerstein (RH) at Voxeu, 6 February 2010, link:

RH, Fed economist, welcome aboard. About 1830 Lord Overstone said it takes about two generations for all traces of financial folly to be wiped from the market's memory. That's about 50 years. Keep looking. RH's seignorage comment is a fancy way of saying the Fed's cost of capital is zero, my 31 January 2010 post: As long as the dollar is seen to hold its value better than other paper currencies, it will continue in use. When it and all other paper currencies are seen as no better than Venezuela's bolivar, worldwide hyperinflation will result. RH, we salute your exposing the source of Fed "profit". The coming inflationary storm will sweep away the euro too. The Fed has an opportunity here, i.e., to encourage other countries to increase their inflation rates, so more people overseas will hold "wealth" in the form of dollars.

1 comment:

Anonymous said...

Liquidity is king.