September 20, 2009


The Future of Global Finance (LIAQUAT AHAMED, 9/20/09, NY Times)

It has long been recognized that the global financial structure — built as it is around the dollar as the world’s reserve currency — has a fundamental design flaw that makes it inherently unstable. The problem was first identified back in the early 1960s by the Belgian-American economist Robert Triffin, in “Gold and the Dollar Crisis.” Writing about Europe’s accumulation of dollars, he argued that the system carried the seeds of its own destruction. Foreigners could acquire dollars only if the United States ran current account deficits — that is, spent more than it earned. But lending money to someone who lives beyond his means has obvious dangers, and the same is true of countries. Thus, the American deficits necessary to supply dollars to the world for international transactions simultaneously undermined confidence in the currency. It was only a matter of time, Triffin predicted, before the system would be hit by a crisis — which it duly was in the early 1970s.

At the beginning of the current decade a group of commentators, the most ­articulate being the Financial Times columnist Martin Wolf, updated Triffin’s critique and applied it to current arrangements. Whereas Triffin had been primarily concerned about the European accumulation of dollars, the spotlight was now on Asia. In the wake of the 1997 financial crisis there, countries in East Asia set out to build up war chests of dollars as insurance against domestic banking runs or downturns in the global economy. At about the same time, China embarked on a program of export-led growth, engineered by keeping its currency artificially low.

Interpretations of what happened next differ. Some argue that to absorb these goods from abroad while avoiding unemployment at home, the United States very consciously stimulated consumer demand. The country, in effect, was forced to live beyond its means. Others believe that the Fed misread the fall in prices as a symptom of inadequate demand rather than for what it was — an astounding, once-in-a-generation expansion in the supply of low-cost goods — and kept interest rates low for an unusually long time, which provoked the real estate bubble.

In either case, the result was an enormous accumulation of dollars in the hands of Asian central banks. Those dollars, when invested in the American bond market, drove long-term interest rates even further down and made credit in the ­United States even more artificially cheap.

The build-up of dollars abroad was also the catalyst for a remarkable transformation in the flow of money around the world. The United States found itself literally operating as a gigantic bank, taking short-term liquid deposits from countries with surpluses and investing the money in long-term, risky assets at home and abroad. The numbers involved were staggering. In 1996, the United States had international assets and liabilities of around $5 trillion. By 2007 the figure was more than $20 trillion. Like any bank, it was vulnerable to a run. The main fear was that the United States at some point would be faced with a modern-day replay of Triffin’s dilemma and would have to deal with the consequences of a collapse in confidence in the dollar.

Instead, what led to the current mess was a somewhat different strain of the same disease. As Wolf traces out so well in his 2008 book “Fixing Global Finance,” the United States was able to absorb all the goods coming out of Asia only by letting its consumers go progressively deeper into debt — a process that had its own limits. Moreover, the flood of money simply overwhelmed the capacity of financial institutions to handle it. A lot, for example, ended up in the most unregulated segments of the global banking system, like off-shore deposits on the books of non-American banks. These banks, now awash with cash and desperate for places to put the money, became easy marks for American investment banks seeking to peddle securitized mortgages. When a large percentage of these loans went bad, instead of a dollar panic we had a global banking crisis.

The ease with which the crisis was dealt with; the immediate return to absurdly high personal savings rates; the reality that global deflation will continue, not end; and the demographics that will force foreigners to put their savings into our credit markets, not their own; all make nonsense of this. But the biggest problem with the theory that there's a design flaw in the system is that countries are generally nothing like someones. If a 70 year old man owes you $1000 you should be worried about ever seeing it--after all, he's no longer earning any money, just spending what he has left, and could die any minute. The 230 year-old democracy that owes you money will be around for centuries after your nation implodes.

Posted by Orrin Judd at September 20, 2009 6:03 AM
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