Wherever I look, including occasional comments on the blog, I keep seeing this as a justification for why the $US will not fall. I feel it is time to address this point of view directly. I have, in part, answered some of the points in a recent post in the notes sections. However, I would guess that not everybody will get as far as the notes and, in any case, the points that I made could do with a little more elaboration and explanation. It is quite a lengthy post, but it must cover quite a bit of ground before it all pulls together at the end.
Before going further it might be useful to think about what a reserve currency actually is. First and foremost it is a way in which governments/central banks can store value, and it will be a currency that is the basis for comparison and execution in trade transactions. This is currently the function of the $US, which is the major reserve currency, with the Euro taking second place and the £GB third place (or perhaps it has slipped from this position of late?). However, in order for it to be the currency of transaction comparison, it must have a strong position in its own right in the world trading system.
At the moment there is no question at all that the $US is important as a reserve currency, and to deny this role would be fatuous. A large amount of trade is transacted in the currency as well as being the primary currency for government/central bank reserves.
However, that this is the current situation does not imply that this will be the situation into eternity. It is worth remembering that the £GB was once the reserve currency, but economic weakness saw it overtaken by the $US. In other words, reserve status is not a magical and unalterable fact. In many cases I sense that the argument against the collapse of the $US is actually a belief that a world in which the $US is not the reserve currency is an impossibility. This is not an argument, but an act of faith - a reserve currency does not exist by magic. The $US became the reserve currency due to the underlying economic strength and weight of the US in the world economy.
Before starting to look at the US role in the world economy, let's first of all be very clear about a particular point. Unlike the UK, the US is still a manufacturing heavyweight, and output of manufacturing has remained strong (the link takes you to an article that proposes that the service economy is supportable but it provides a useful chart), despite the decline of numbers of people employed in manufacturing.
In addition (again unlike the UK) added value from manufacturing in the US has been increasing. However, the same can be said of many competitors of the US, such as China. I found it very hard to find good data for this but did find this rather useful table (I suggest you pause and take a look at the link and the added value columns, taking particular note of the US and China).
As you will see in the table, the relative growth rates in added value between for example China and US are not very encouraging for the US on balance, and the data only goes to 2001. We should remember that China's growth rate has been accelerating. This is not to take away from the real gains in the US, but to emphasise that the position is relative slipping in comparison to China. I think we can safely assume that China's growth in added value will have seen very significant improvements since 2001, and we might speculate that the US may have gone into decline. At the very least, it is unlikely to have seen much growth (if anyone has better and more up to date figures, please feel free to post the link, as I do not like to make assumptions).
What we have here so far is not too bad a picture. The US appears to be doing well, but others are catching up fast.
However, this is not the whole story as, for example, the last point in time at which there was a US merchandise trade surplus was 1975. What this means is that the US consumes more than it produces in merchandise. Set against this, it might be argued, strength does not just lie in manufacturing but also as income from investments and export of services, intellectual property and so forth. The problem here is that the US has been running a continual current account deficit for a very long time. In other words, the US as a whole is running, in very crude terms, at an ongoing operational loss.
What we have here is a mixed bag of statistics and information, but no clear sense of what this actually means.
In order to understand what this actually means, there is a very curious and rather apt analogy that we can make with the US economy and the troubles of the US car industry. We might think of the US as General Motors (GM), and China as being like Toyota (we could add in Europe as Ford, and so forth, but for simplicity we will just look at the two). There are many parallels that we can make between the US auto market, and the world economy. An obvious parallel is the increase in market share of Toyota at the expense of GM, the ongoing losses at GM and the ongoing (until now) profits at Toyota. In both the US car market and global economy, there has been growth, but in both cases there has been a building of overcapacity (with resultant tough competition).
Added to this we have a contraction of demand in both the world economy, and a (more) dramatic contraction in the US automotive market. This contraction is cruelly exposing the weaknesses that were not so apparent in the 'good times'. This resemblance is most helpful to illustrate the bad state of the US economy, in particular if we think of the bailout of GM by the US government.
In the case of the GM bailout, the US government quite reasonably pointed out that GM had been having difficulties for a long time, and that the problems were evident during the good times. GM were already loaded up with mountains of debt, were saddled with huge structural legacy costs, their workers were paid far more than the workers in the Toyota factories, but with no advantage to explain this differential. They had been increasingly bleeding money. Whilst GM were still producing volume, they were simply not turning that volume into an overall profit. This might be a description of the US economy as a whole in comparison with China, although in an exaggerated form.
As a result of the fact that the problems were long standing, key conditions of the bailout were that GM management addressed the problems of both their legacy costs, as well as the wage differential between their workers and the Toyota workers. This was the minimum that was required. The government was willing to tide GM over for a short period, but only on the basis that they would have a breathing space to deal with these issues, and come back with a plan on how to move from making a loss to eventual profitability. This latter point will be the basis for any further assistance.
Few would argue that these demands are not reasonable, as the government wants to know that it is not going to be pouring money into a black hole (though, this is of course a political process, so whether the politicians will ever actually look at the eventual plan in a realistic and hard headed way is questionable). Few would also dispute that the declining market share of GM in relation to Toyota, the ongoing losses, are a big worry, and that the government is right to demand a plan from GM to show the way to profitability. Quite simply, the government does not want to throw money into a company that has no clear route to ever returning to profit.
It is at this point we need to ask the question about whether the US government is treating its own plans for the US economy in the way that it has treated the GM bailout. The US is still producing volume, but is operating at a loss. It is losing market share to a rival, which has been growing steadily and doing so profitably. Whilst both are suffering in the current market conditions, one has a large surplus with which to tide itself over, and the other is saddled with large debts. One is relatively loaded with legacy costs and the other is relatively free of such costs. In the past, GM and the US had a strong technological advantage, but even that advantage is eroding rapidly. In the case of the automotive industry, companies like Toyota appear to have surpassed GM in development, but this is not the case for the US economy and China. However, the differential is fast eroding, with China rapidly climbing the technological value chain.
If we look at the financial position of GM and the US at the moment, in very broad terms, they are aslo in a similar position. They share the problem that, even as debt is increasing, revenues are rapidly decreasing. This means that the debt is growing in both absolute terms, and in relation to revenue. This means that there is ever less income with which to service the existing debt, let alone any new debt.
I will not pretend that the US economy are the same, but the comparison/analogy does illustrate an important point when we consider the bailouts.
Whilst the bailout of GM is contingent (in principle) on a clearly defined route out of trouble, including a reduction in structural costs of the business, no such clearly defined route to reverse the deficits is being outlined for the US economy. It is just believed that, somehow, it will all come right in the end. For example, the GM autoworkers are being told that they will have to accept a cut in their pay and benefits package to narrow the gap with the Japanese transplant factories. As yet, no solid proposals for such plans have been forthcoming for the US economy. Various commentators are suggesting that there will be proposals to control the spending on welfare programmes for example, but nobody is saying that spending will be reduced.
In the case of Irwin Stelzer, his interpretation appears to be that the 'control' of expenditure will happen at some undisclosed notional better economic time in the future. In other words, everything will carry on as before, with any hardship delayed to some notional point in the future. Such a proposal from GM would rightly be regarded as a completely unrealistic denial of their underlying situation. Apparently, for the US economy, the same principles do not apply. If the stimulus/US bailout plan were subjected to the same basic consideration as the GM plan, it would be thrown out without any hesitation. It does not address the basic problems of the US economy at all.
As an aside, in one other respect, we have another curious comparison. One of the conditions of the bailout of GM appears to be that it must invest in electric cars. There is no proven market for these cars, no reason to believe that they will be a success, but a significant slice of their investment programme will be devoted to this cause. In much the same way, the US government is pouring 'stimulus' money into various green programmes. In both cases, there is a situation of significant financial problems, and in both cases precious capital will be sunk into activities with dubious prospects of positive returns. In both cases, economic pragmatism is bowing to the interests of politics. As I mentioned, an aside.
Overall, what we have is a situation in which the US government is seeking to rescue the economy in a way that would not pass their own criteria for the bailout of GM. The US government would not award a bailout to itself if it asked the same questions of itself as it did GM. It seems the basic questions that apply to GM do not, for no apparent reason, apply to the US economy. Overseas creditors will be taking note of the lack of a clear plan for return to surplus. They are not fools.
This should be a worry....but the $US is a reserve currency, so its ok. The US can just keep creating money, and all will be well. As I have mentioned, the US government is not an automotive manufacturer - we should remember that the US is a sovereign country, not a company able to turn to its own government as lender of last resort. In the case of the US government it has the central bank, and more of that later...
If the US wishes to borrow (aside from the central bank), it has two avenues for borrowing. On the one hand, it can use the deposits of US savers who, through the banking system, can buy government bonds. However, as we are all aware, the government is having to lend large amounts of money to the banks in order to prevent their bankruptcy, as they are insolvent and have lost much of their depositor's capital. The fact that the banks are also then lending this government money back to the government does not help in terms of clarity, but a money-go-round does not actually increase the finance available to the government through borrowing, and more of that later....
The bottom line is that the only way that the US government can really continue borrowing in normal ways is by raising money in international markets, and that means gaining finance from the surplus countries such as the oil producers and the big exporters like China and Japan. There is also potential for funding from countries like the UK where there is increasing nervousness about holding the £GB, and where the $US is still seen as a safe haven. The trouble is that, at this moment in time, all across the OECD governments are all on simultaneous borrowing binge, meaning that there is significant competition for available capital.
So far, the US has done very well out of this, as there has been a 'flight to safety', with the $US seen as a safe haven. This is the advantage of being the main reserve currency. It is the natural place to go when the markets are spooked. As a result, the $US has managed to defy gravity, and has remained relatively steady.
However, I will now quote a note from my previous post, regarding one of the major creditors to the US (again I am discussing China but the principle will apply to other holders of $US reserves):
However, a good way of looking at this is to think of yourself in the position of Hu Jintao. He is seeing that his exporters are collapsing, and that the growth necessary for stability is dropping away. Set against this, he has huge piles of foreign currency, a strong position to spend to support his economy. However, he has a difficult problem.What I am pointing to here is a big contradiction. The $US is the reserve currency by tradition, but it is now clear that there is a fundamental problem with the currency. It is close to being completely unusable. This is not a reserve currency in that it is not a store of value.
All the while his economy has been growing, it has accumulated massive reserves of foreign currency. In order to enact a stimulus, he really needs to utilise some of these reserves in order to prop up his economy. However, in order to utilise those reserves, they need to be sold into the market place to buy, for example, the commodities that will be required in support of infrastructure projects. If China starts trying to sell those reserves, he is in a position where there will be a flood of the currencies onto the markets. That flood of currency will depreciate the currency, as there are not enough goods to be purchased in the currency, and likely little demand at this time to use the currency as a reserve. During the downturn, others will equally want to use their reserves to finance their way through the trouble, rather than accumulating greater reserves.
If we look at the $US, if this is sold into the market, and sees the resultant depreciation, then there will be further troubles for exporters. Although the RMB is not a free floating currency, if the $US depreciates, and the RMB does not appreciate, the US will (quite reasonably) howl with rage, and will take protectionist measures. If that is the case, China can say goodbye to one of the major export markets.
In other words, what China has done is accumulate currency that it dare not use as, if it uses the currency, it will destroy the currency. The only solution available will be to try to discreetly sell as much of the currency as it can without 'spooking' the markets.
The trouble is that, with so many countries holding these $US reserves, most of whom have their own economic problems, it is likely that everyone is having the same thoughts, and confronting similar problems. What you have is a situation in which there is something like a Mexican stand-off. As soon as one starts selling, then everybody must start selling. They are all, at the same time, terrified of selling, because in doing so, they destroy the value of what they are selling. It is a time bomb just waiting to go off.
The problem is more serious than I have suggested in the above quote. Mr. Hu is facing an even sharper dilemma. He has all of these $US reserves, a currency that he dare not use, but he will become increasingly in need of something to prop up his own economy. However, as we are all aware, the US is now on the path of quantitative easing, or printing money without constraint. At present, this has not yet fed into inflation but, as I explained in a previous post, the government is acting as a buffer soaking up the newly minted money before it actually reaches the market. A large part of the new money goes through the money-go-round creating a buffer, and the newly created money must go through the government before reaching the open market, and the government thereby also acts as a buffer on the money reaching the market. However, as the governments plans are enacted, this new money will eventually appear in the market place.
In a previous note on a post, I had the following to say regarding the UK, but it applies to the US:
If, for example, the banks use money to finance borrowing of overseas governments, this is a net outflow of currency, which will further weaken the £GB. If the money remains in the UK, it will eventually reach the economy in the form of loan guarantees, and various other government stimuli measures. In all cases, the money does eventually reach the market. The important point in all of this is that there is a significant buffer in all of this, which is the ability of the government to actually utilise the money such that it reaches both businesses and consumers in the UK.I believe that in the case of the US, the freshly printed money is going straight to the banks, then is being lent to the US government, with very little going outside the US. As such there is going to be an increase in the money supply in the US in the near future, and that money will have nowhere to go except to chase a limited number of goods and services. The reason for this is quite difficult to explain, but I will try my best.
The first consideration is the supply of $US over time. There is a chart here which shows the massive amount of $US reserves that are now held by governments around the world. You will note the amazing rate of growth. One of the reasons that has been cited for the growth in reserves was the experience of the Asian crisis, but I will leave that to one side for the moment. The important point is that, as fast as the US could create money, it has been soaked up as increases in reserves around the world.
At the same time as this has happened, there have been several asset bubbles in the US, including the housing bubble. These have also soaked up the increase in money.
The problem here is that the US central bank has been pumping out huge amounts of money out with no apparent inflation. Like many central banker fixations, they have obsessed about inflation. Inflation happens when there is too much money chasing a limited number of goods or services. However, what has been happening is that the huge amount of printed money has been soaked up by central banks for reserves, and soaked up in asset price inflation, such that it has not been chasing goods and services. Furthermore the supply of goods has been increasing with the growing productive muscle of the emerging economies. As such, there has been a combination of very serious inflation in the money supply in the US without a corresponding increase in measured inflation.
Now the expression measured is very important, because asset price inflation did not count in official inflation. In particular, as fast as new money was produced, asset prices such as houses inflated. Greenspan, in his wisdom, allowed one bubble after another to soak up the expansion in money. However, we have now gone one bubble too far, and there is no new bubble on the horizon to soak up the money being dropped into the market (which would in any case just be a delay, not something that would be a 'good' thing). As such, one of the sources of money absorption has been bubbles in assets, which stopped the prices of other goods going up. Mainstream economists seem to think inflation was conquered, but it was just displaced into something that was not measured.
The other absorber of $US I mentioned was the steady accumulation of $US reserves by central banks. To understand this we have to once again imagine Mr. Hu in his Beijing office. Mr. Hu has a series of dilemmas with which he must wrestle.
On the one hand, he has more reserves than he can possibly do anything with. If he uses them, he destroys them. However, he needs to save his own economy. One way of doing that is to keep the exports flowing to the US. However, if he does that, he will simply accumulate even more reserves which he can do nothing with. Furthermore, if he is looking at the US plans with any kind of critical evaluation (which he has hinted at) then he will not see great prospects for the future value of the $US reserves.
In addition, without the exports to the US, Mr. Hu will see further contraction in his own economy, and possibly social unrest. In order for the exports to save him, he must accept the continuation of a system in which China exchanges pieces of paper with nice pictures on them in exchange for goods. In other words he must finance US consumption with massively subsidised Chinese production.
The problem is that Mr. Hu is not alone. There are many people sitting on $US as reserves but with very little that they can do with them. The trouble is that the money was issued without a corresponding growth in the output of value in the US economy. Instead of real growth in value, there was an apparent growth due to debt fuelled consumption. As such, there has been a significant growth in the supply of money without a significant growth in real output of value. As I have pointed out in many posts, GDP is a sham figure that is meaningless unless the source of the activity is included. Debt driven consumption produces significant activity now, but at the cost of future activity. It does not signify that an economy is creating more value or wealth, just more activity. In the case of debt fuelled growth, it is a mirage.
As such, what we have is a situation in which there has been a massive expansion in the money supply, but no commensurate sustainable expansion in the products or services that the money supply can purchase. As such supply of $US has outstripped the supply of US produced goods and services, and by a very large amount.
If we return to Mr. Hu, and those in a similar position, the only way out for them is to continue to soak up ever more $US. This is because there is now no assset bubble within the US to soak up the newly created money coming off the printing presses. There is no place for the newly created money to go into the US economy as it does not produce enough goods and services to soak up the money. This means that the only place it can go is overseas, meaning yet further $US accumulating in reserves overseas.
The trouble is that they already have more $US than they can do anything with. The fact that the $US is a 'reserve currency' is what has allowed for the destruction of the currency. As long as the $US was the reserve currency, it was possible for more and more to be issued for other central banks to accumulate, and this situation was not a problem - right up until now when all of the holders of the reserves need to actually utilise them. It is now that their real status as a reserve currency is being tested - that test is their worth as a store of value. It is failing that test.
In such a situation, the mantra that the $US will be saved because it is the 'reserve currency' starts to look increasingly weak. Here are the fundamental questions:
Why would anyone want more $US when the reserves that they have are already beyond any utility? For example, why would China wish to continue to pay for US consumption with their labour and savings? Why would any country wish to do this, as many other countries are in the same position of holding large $US reserves? As such, I would ask those who argue that the $US will not fall 'because it is a reserve currency' the following question:
'Under what circumstance do you think that a currency might lose its status as a reserve currency?'
In other words, how much money does the US need to pump into the market before every country, every individual, and every organisation calls 'enough'? How completely useless must the currency be before it collapses. Quite literally, there is $US trillion + out there, which no one can find any use for. If they use their reserves in any quantity, they risk destruction of their reserves.
Do the defenders of the $US as a reserve currency think that the creditors have not noticed that they are sitting on piles of paper they can not use? Do they think they are not analysing the US stimulus plan and not going through every detail looking for the time when they will be repaid for their loans? They are sitting on their reserves, and probably wondering if they will ever be of any use, of any value. With more money being pumped out, they will be getting very agitated. When they look at the stimulus plans, all they will see is ongoing deficits, and no plan for return to a surplus. Ever.
I must emphasise this point. At no point has anyone in the US government to my knowledge offered any plan that has not involved ongoing increase in debt, increase in the money supply, and there has been no plan whatsoever to return to surplus.
Under the current circumstances the $US is not a store of value, but a destroyer of value. I can almost visualise the meetings in governments around the world, as brows furrow over the central problem of the $US. What will be causing those brows to furrow is that, if the $US goes down, the world economy will follow it on down. On the other hand, if everyone holds on to the $US, the only way they can save it is through absorbing an ever increasing supply of $US, which means an ongoing financing of US profligacy in return for a currency of ever faster decreasing value.
Furthermore, the massive increase in supply of $US that comes with quantitative easing is just going to make the value of their existing $US more questionable, even without the prospect of adding more junk to the pile. The greater the supply of $US that are printed, the more that everyone is subsidising the US at the expense of their own economies and their own populations.
There is even worse than this for the $US reserve holders. Either they absorb those excess $US that are being created or that money will sit in the US chasing the limited stock of goods and services that are available from the US economy itself, thereby creating hyper-inflation within the US, and thereby also destroying the value of the $US. Either they subsidise exports and absorb the new money, or the value of their reserves is destroyed.
They must finance the US deficit and trade imbalances, or the $US is junk, and the world economy becomes junk with it. As I said, a Mexican standoff. Someone is going to blink, start selling the $US, and everyone will follow. The dollars will pour into the market.
I suspect that the US government and central banks around the world are in regular discussion on this issue, though less directly than I have put it here. It will be dressed up in nice language, and will all be terribly civilised and discussed in technical evasions of the reality. However - there will be a subtext - on the one side the US will be pointing to an apocalypse if the $US falls, and on the other side there will be the furrowed brows.
It is a very fragile situation, and it just needs a small push.....
Note 1: This has been a very challenging post to pull together, so I am worried that I may have missed points, or not been as clear as I should be. As such, any comments will be very welcome, in particular if there are any inconsistencies in the post.
Note 2: In a table earlier, you may also note that the UK has seen growth in manufacturing output, but this brings me to an interesting point. I will quote my first essay for the blog as follows:
'According to an EMEA report, gross added value from manufacturing in the UK saw a rise in the mid-nineties, followed by a decline in the early 2000 period, a decline that led to the added value falling back in 2005 to where it had been in 1999. 'I have put this in as an aside, in case the figures in the table encourage a false sense of confidence in the UK economy. Also, you will see from another table I linked to a similar picture.
Note 3: This is a very long post, and I apologise for not responding to comments this time. However, many thanks for the comments and the many very useful and interesting links.
Note 4: I am aware I am focusing on China but, as I have mentioned in many posts, China is increasingly in the driving seat for what happens next. Of course, it is only one player amongst many, but it is an increasingly important player with potential to effect significant change. For example, if China were to bite the bullet and continue to finance US deficits....then the day of reckoning for the $US might be delayed for a while yet (though will still happen eventually).