Dollar Dreams or Nightmares?
People come into the United States of America with the dollar dream, wanting to earn the green back and send it back to their own country. They dream of buying houses back home, helping to finance their siblings' education, wedding etc. etc. But what exactly happens to those dollars? They are converted into the country's currency by some foreign currency exchange shop which in turn replenishes these dollars to the central bank of the country. The central bank has many other sources of getting these dollars the biggest being exports to the world's largest consumer (the US of course).
Now what should the bank do with all these dollars? They would want to save some as reserves for rainy days (they need to import food, prevent their currency from devaluing) as well as for buying gas. It is interesting here to note that gas could till recently be bought only in US dollars in the NYMEX and the London Oil & Gas exchange. This point deserves a separate blog post in itself. The rcentral bank needs to invest the remaining dollars somewhere and the safest option amongst all is the US treasury bonds - sheets of paper for which the US government is a guarantor. Hence in effect the money is reaching the USA again!
So let's get this straight - those in the US are spending money buying goods exported by countries like China, the Chinese in turn are saving this money and putting it into their banks as their banks are giving them high interest rates to control the inflationary pressures due to such heavy exports, the banks are keeping these reserves with their central bank and the central bank is buying US treasuries and in effect sending the money back for the US to spend. That is such an enviable position to be in, especially considering that the US government can in effect pay interest on these bonds simply by printing more dollars. It is an unlimited line of credit that the US has created for itself!!
Some call this arrangement the Bretton Woods 2 system. The original Bretton Woods system was formulated after WWII when the US was the only country with financial prowess and Europe and Asia needed to heavily borrow from the US to grow. The dollar was pegged to gold and it was then in the interest of most countries to grow their dollar reserves as there was a guarantee of fixed amount of gold by the US government. This peg was removed in the 60s when countries like France wanted gold back in lieu of dollars. Bretton Woods 2 has China on one side keeping dollar reserve with the US spending money on the other.
That leads to the question that everyone is asking - how long can this last? There has to be a breaking point somewhere. There is no count of the total dollars out there. With the decrease in the US interest rates due to a meltdown in the housing market, the return on investment on new treasuries for other countries will go down. No one will want to hold long dollar positions and there will be heavy selling. The dollar will fall in value and most central bank reserves will get wiped out in terms of their values. The American power to import and consume will fall drastically leading to a global recession (until and unless other consumers take their place). This is a very simplistic way of looking at it, but a distinct possibility. We can just hope that the powers that be can come up with a better solution to the current deficit problem that we face. We cannot afford to continue our profligate behavior - there has to be a full stop placed somewhere. The dollar will fall in value - hopefully to a manageable extent and the generation after ours will also continue to have dollar dreams instead of dollar nightmares.
Now what should the bank do with all these dollars? They would want to save some as reserves for rainy days (they need to import food, prevent their currency from devaluing) as well as for buying gas. It is interesting here to note that gas could till recently be bought only in US dollars in the NYMEX and the London Oil & Gas exchange. This point deserves a separate blog post in itself. The rcentral bank needs to invest the remaining dollars somewhere and the safest option amongst all is the US treasury bonds - sheets of paper for which the US government is a guarantor. Hence in effect the money is reaching the USA again!
So let's get this straight - those in the US are spending money buying goods exported by countries like China, the Chinese in turn are saving this money and putting it into their banks as their banks are giving them high interest rates to control the inflationary pressures due to such heavy exports, the banks are keeping these reserves with their central bank and the central bank is buying US treasuries and in effect sending the money back for the US to spend. That is such an enviable position to be in, especially considering that the US government can in effect pay interest on these bonds simply by printing more dollars. It is an unlimited line of credit that the US has created for itself!!
Some call this arrangement the Bretton Woods 2 system. The original Bretton Woods system was formulated after WWII when the US was the only country with financial prowess and Europe and Asia needed to heavily borrow from the US to grow. The dollar was pegged to gold and it was then in the interest of most countries to grow their dollar reserves as there was a guarantee of fixed amount of gold by the US government. This peg was removed in the 60s when countries like France wanted gold back in lieu of dollars. Bretton Woods 2 has China on one side keeping dollar reserve with the US spending money on the other.
That leads to the question that everyone is asking - how long can this last? There has to be a breaking point somewhere. There is no count of the total dollars out there. With the decrease in the US interest rates due to a meltdown in the housing market, the return on investment on new treasuries for other countries will go down. No one will want to hold long dollar positions and there will be heavy selling. The dollar will fall in value and most central bank reserves will get wiped out in terms of their values. The American power to import and consume will fall drastically leading to a global recession (until and unless other consumers take their place). This is a very simplistic way of looking at it, but a distinct possibility. We can just hope that the powers that be can come up with a better solution to the current deficit problem that we face. We cannot afford to continue our profligate behavior - there has to be a full stop placed somewhere. The dollar will fall in value - hopefully to a manageable extent and the generation after ours will also continue to have dollar dreams instead of dollar nightmares.
posted by ritwick at 9:55 PM
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