The Dollar Trap - Book Review
Why US dollar will continue to be the world’s reserve currency, despite obvious flaws
 
The US dollar has been the king of currencies for decades. Foreign investors regularly pour billions of dollars in financial assets denominated in dollars, allowing the US government and households to maintain high levels of consumption through cheap borrowing, something that many experts have declared to be unsustainable. 
 
Therefore, numerous articles and books have appeared over the past decade which predict that the dollar would crash creating global instability. However, one of the most obvious questions to ask is: Crash against what? A currency’s value is relative. It is expressed in relation to other currencies. Euro is as weak. Renminbi is not a global currency as the US dollar and the gold standard is too restrictive for modern financial world. And, so, disappointing many forecasters, the dollar remains the king of currencies. 
 
But the deep flaws in the dollar-dependent global system cannot be wished away. Eswar Prasad, a professor at Cornell University, formerly the head of China division of the International Monetary Fund, has done work on the Indian financial sector reforms. He makes a nuanced argument that, while the dollar is flawed as a global reserve currency, it can’t be replaced and we will, therefore, have to live with it, with all its potential dangerous implications.
 
The book starts by setting the context in which the dollar has to be analysed—the global financial economy. Prasad provides a guided tour through some key analytical concepts of the international monetary system and the framework economists use to study capital flows. 
 
He also analyses how rising integration into global financial markets has affected these economies’ external balance sheets. Emerging markets are now less reliant on foreign debt and more on foreign direct investment. But these economies face new dangers—portfolio flows and asset market boom-burst cycles fuelled by those flows. This, paradoxically, explains the dollar’s strength, defying the predictions after the 2008 crisis, that the dollar would crash. 
 
With hindsight, two factors explain the continued dominance of the dollar. One, frequent global scares in financial markets, coupled with geo-political tensions, have meant a growing importance of ‘safe assets’, investments that at least protect investors’ principal and are relatively liquid (i.e., easy to trade). Two, emerging economies have a strong incentive to accumulate a massive war chest of foreign exchange reserves to insulate themselves from volatile capital flows. Indeed, the global financial crisis shattered conventional views about the level of reserves needed to protect an economy from the spill-over effects of global crises. Even countries, that had a large stockpile, found their reserves shrinking rapidly during the crisis, to protect their currencies from collapse. So, now, the new cry of policymakers in many emerging markets is: We can never have too much of reserves. 
 
Prasad asks, “Does it make sense for other countries to buy increasing amounts of US public debt, when the amount of the debt is ballooning rapidly and could threaten US fiscal solvency?” There are no answers to this. Countries have no option but to buy dollars and so they are sending more and more money into the US. Prasad argues that “foreign investors, especially the central banks of China and other emerging markets, are willing participants in an ostensible con game set up by the US.” After all, foreign investors hold about half of the outstanding US Federal government debt. 
 
In this situation, the US can theoretically act like other indebted countries—print more dollars, thus reducing the value of that debt. The US has been presumed to be doing this but, surprisingly, has escaped the consequences of such action: higher inflation. Indeed, this is what many experts predicted would happen after 2010, some even predicting hyperinflation. But inflation has been low and US is now reducing the quantitative easing without any impact on bond yields—another surprise.
 
So, what happens to the dollar’s future? Domestic inflation will not rise much and foreign investors would continue to be frustrated as they have no option other than the dollar even though they know that the dollar would weaken over the long term and they are destined to lose money. It’s an uneasy relationship, with no end in sight.

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COMMENTS

Peter Palms

3 years ago

Indeed, it is rather obvious that the only thing which cannot have a price is money!

Monetary Realists--both of us--are like the little boy in the story of the Emperor's new clothes. Untrained in economics, we do not know what we are supposed to see; and we have escaped the indoctrination, a.k.a. education, which instructs us to see what isn't there, and assert what we do not know as true.
An example: responding to the depression of the '30s, President Roosevelt "revalued gold from $20.67 to $35 per ounce." The quote is from the estimable and learned Vronsky, from his article at this site, "A Possible 1999 Scenario." The quote is buttressed by another quote from "contemporary experts: "In an effort to rise out of the economic depression, and generate more employment, FDR on January 31, 1923, devalued the dollar by raising the price paid for gold by the U.S. Treasury." And indeed, there is virtually unanimous agreement among the cognoscenti that Roosevelt did, indeed, "raise the price of gold" by his action of 1931. May a small timid voice ask, "Did he?"
What ever happened to the meaning of words? Let us look at Roosevelt's actions through the eyes of the little boy at the Emperor's parade.
"--raising the price of gold." How does one pay a price? In money. What, specifically, was American money in 1934? Well, for foreigners, it was gold, although American citizens had had their money stolen by FDR in 1933. So our government, specifically the Treasury, was going to pay more money for gold subsequent to Roosevelt's ukase. But gold WAS money; money WAS gold! To pay more money for gold meant paying more gold for less. The dollar was .0483 ounce of gold, when the dollar was standardized at $20.67/oz. With the dollar at $35.00/oz, it was .0286 ounce. So the government announced, in what is generally regarded as a stroke of economic savvy and sophistication, that it would pay gold for gold, and that to buy .0483 of an ounce, it would pay .0286 ounces! Moreover, it announced that this was an "increase" in the price of gold! And people believed it, and still do!
But it probably never happened that way. The idea, after all, was to cheapen the paper currency. You can't cheapen gold! So Mr. Roosevelt and his henchmen would offer foreigners 35 Federal Reserve "notes" for an ounce of gold which had previously been "worth" 20.67. Wow! What a deal. Apparently, many went for it. However, should those foreigners decide to take the $35.00 from the sale of an ounce of gold, and use it to buy gold, they would end up with what they sold in the first place: an ounce of gold. No profit whatsoever. If they used the "dollars" (of what?) to buy $100 worth of gold they would have ended up with $59 worth of gold of the previous value, which they had sold so "profitably." A loss! But if they used the paper currency, not to buy gold, but to buy American products, they could buy more of them, since their prices had not changed. The producers of those products, however, would have to accept "dollars" worth only 59 cents!
What a protection for the American worker! The extent to which he was being robbed, however, was not apparent to him, because the government had, the year before, stripped him of gold ownership, so that he could not take his "dollars" to the bank and test them. And with more Americans working (albeit at a 41% discount!) the appearance of prosperity was undeniable.
What a malign institution is government! Designed to protect the rights of the people, it robs them under the guise of protection! And it does this to solve problems of its own making. Robbing the people it was created to protect, it enriched foreigners at the expense of those very same people.
Interestingly, it found this job easier because a gullible people either did not demand, or did not understand, the meaning of words; especially that most important word "dollar." Today it is a legal fiction for which we are expected to give our lives, at least to the extent of 40 hours weekly. In 1934, it did have a meaning, but no one asked, or no one cared. Neither did anyone question why anyone would use gold (money) to buy gold, or give less gold for more. Indeed, it is rather obvious that the only thing which cannot have a price is money!


Peter Palms

3 years ago

Indeed, it is rather obvious that the only thing which cannot have a price is money!

Monetary Realists--both of us--are like the little boy in the story of the Emperor's new clothes. Untrained in economics, we do not know what we are supposed to see; and we have escaped the indoctrination, a.k.a. education, which instructs us to see what isn't there, and assert what we do not know as true.
An example: responding to the depression of the '30s, President Roosevelt "revalued gold from $20.67 to $35 per ounce." The quote is from the estimable and learned Vronsky, from his article at this site, "A Possible 1999 Scenario." The quote is buttressed by another quote from "contemporary experts: "In an effort to rise out of the economic depression, and generate more employment, FDR on January 31, 1923, devalued the dollar by raising the price paid for gold by the U.S. Treasury." And indeed, there is virtually unanimous agreement among the cognoscenti that Roosevelt did, indeed, "raise the price of gold" by his action of 1931. May a small timid voice ask, "Did he?"
What ever happened to the meaning of words? Let us look at Roosevelt's actions through the eyes of the little boy at the Emperor's parade.
"--raising the price of gold." How does one pay a price? In money. What, specifically, was American money in 1934? Well, for foreigners, it was gold, although American citizens had had their money stolen by FDR in 1933. So our government, specifically the Treasury, was going to pay more money for gold subsequent to Roosevelt's ukase. But gold WAS money; money WAS gold! To pay more money for gold meant paying more gold for less. The dollar was .0483 ounce of gold, when the dollar was standardized at $20.67/oz. With the dollar at $35.00/oz, it was .0286 ounce. So the government announced, in what is generally regarded as a stroke of economic savvy and sophistication, that it would pay gold for gold, and that to buy .0483 of an ounce, it would pay .0286 ounces! Moreover, it announced that this was an "increase" in the price of gold! And people believed it, and still do!
But it probably never happened that way. The idea, after all, was to cheapen the paper currency. You can't cheapen gold! So Mr. Roosevelt and his henchmen would offer foreigners 35 Federal Reserve "notes" for an ounce of gold which had previously been "worth" 20.67. Wow! What a deal. Apparently, many went for it. However, should those foreigners decide to take the $35.00 from the sale of an ounce of gold, and use it to buy gold, they would end up with what they sold in the first place: an ounce of gold. No profit whatsoever. If they used the "dollars" (of what?) to buy $100 worth of gold they would have ended up with $59 worth of gold of the previous value, which they had sold so "profitably." A loss! But if they used the paper currency, not to buy gold, but to buy American products, they could buy more of them, since their prices had not changed. The producers of those products, however, would have to accept "dollars" worth only 59 cents!
What a protection for the American worker! The extent to which he was being robbed, however, was not apparent to him, because the government had, the year before, stripped him of gold ownership, so that he could not take his "dollars" to the bank and test them. And with more Americans working (albeit at a 41% discount!) the appearance of prosperity was undeniable.
What a malign institution is government! Designed to protect the rights of the people, it robs them under the guise of protection! And it does this to solve problems of its own making. Robbing the people it was created to protect, it enriched foreigners at the expense of those very same people.
Interestingly, it found this job easier because a gullible people either did not demand, or did not understand, the meaning of words; especially that most important word "dollar." Today it is a legal fiction for which we are expected to give our lives, at least to the extent of 40 hours weekly. In 1934, it did have a meaning, but no one asked, or no one cared. Neither did anyone question why anyone would use gold (money) to buy gold, or give less gold for more. Indeed, it is rather obvious that the only thing which cannot have a price is money!


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Nifty, Sensex will struggle to rally – Thursday closing report

The recent upmove in Nifty seems mature. However, the index may take a few more sessions to head lower

 

We had mentioned in our Wednesday closing report that the NSE's CNX Nifty will be headed lower if it closes below 7,850. On Thursday the benchmark barely managed to keep itself above this level and hit a low of 7,856. The market opened marginally higher and managed to move higher in the morning session. However, the upward move could be sustained only upto 10:42am after which the indices started moving lower.


S&P BSE Sensex opened at 26,323 and moved up to 26,465 while the Nifty opened at 7,875 and surged to 7,920. Soon the indices gave up all their intraday gains and edged lower. In less than an hour of trading in the negative, the indices hit a low of 26,263 and 7,856. Recovering from the red, the indices tried moving higher but after trading in a range, they managed to close a little above Wednesday’s close. Sensex closed at 26,360 (up 46 points or 0.17%), while Nifty closed at 7,891 (up 16 points or 0.20%). NSE recorded a volume of 83.52 crore shares. India VIX rose 0.53% to close at 13.7325.


There have been reports that some progress was made on the proposed goods and services tax (GST), after the empowered committee of state finance ministers decided on Wednesday, that the common threshold for levy of GST would be kept at Rs10 lakh in general category states and Rs5 lakh in special category states.


Oil Secretary Saurabh Chandra said that the under-recoveries of oil companies will come down substantially in the current fiscal, ending 31 March 2015, on account of better pricing and stable global crude prices.


Union Bank of India, Indian Bank, Bank of India, Federal Bank and PNB were among the top 10 gainers in the ‘A’ group on the BSE. All the bank stocks in the Sensex 30 pack, State Bank of India, HDFC Bank, Axis Bank and ICICI Bank were among the gainers. Finance Minister Arun Jaitley on Thursday said that the government was working to tighten up risk management in the banking sector.


NTPC (1.86%) was the top loser in the ‘A’ group among the Sensex 30 stocks. There was news that NTPC is exiting its non-core assetsn comprising 1,611 megawatt of hydel power projects, it will be selling them to public sector units including National Hydroelectric Power Corp and others that possess core competence of executing hydro power projects.


Titan Company (6.04%) was among the top four gainers in the ‘A’ group on the BSE.

 

Today the stock hit its 52-week high after Morgan Stanley upgraded the stock to 'overweight' from 'underweight' earlier.


Bhushan Steel continued to hit a new 52-week low and was the top loser (4.97%) in the ‘A’ group on the BSE. The stock has fallen 67% since 1st August (Rs394.85) before  the news of the company's involvement in the Syndicate Bank bribery scam surfaced.


Amara Raja Batteries, which hit its 52-week high on Tuesday, was among the top two losers (4.38%) in the ‘A’ group on the BSE.


US indices closed mostly higher on Wednesday. The minutes from the Federal Reserve's July meeting showed that the central bank is in no rush to raise interest rates.


Asian indices showed a mixed performance. Nikkei 225 (0.85%) was the top gainer, while Seoul Composite (1.38%) was the top loser.


The HSBC/Markit Flash China Manufacturing Purchasing Managers' Index (PMI) fell to 50.3 in August from July's 18-month high of 51.7, missing forecasts.


European indices were trading in the green. US Futures too were trading marginally higher.


Data released today showed that German services and manufacturing activity slowed in August. The preliminary reading of a Purchasing Managers Index for the two industries fell to 54.9 in August from 55.7 in July, London-based Markit Economics said. A reading above 50 indicates expansion.


French manufacturing activity contracted for a fourth month in August, signaling that the euro area's second-largest economy is unlikely to return to growth after stagnating in the first half. A Purchasing Managers Index for the manufacturing industry fell to 46.5 in August from 47.8 in July, London-based Markit Economics said today, 21 August 2014. That's the lowest level in more than a year. A composite gauge of both manufacturing and services activity rose to 50 in August, the mark that divides expansion from contraction, from 49.4 in July.

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