Guest Post: Making The Last Use Of Reserve Currency Status

Making The Last Use Of Reserve Currency Status
I suspect many in the mainstream academia haven't realized what QE2 is. It is the last use of the dollar's reserve currency status, intended or otherwise.

In a fiat currency system, inflation should be the only risk, because fighting deflation should be trivial -- just print money. This is a fundamental advantage of a fiat system over the old gold standard. Unfortunately for the US, the dollar's reserve status means the geopolitical border is not the dam holding the water as in other countries. As Fed pours in more water, it leaks right out to lowlands (good investment destinations) all over the world. Given the current economic prospects in the world, the result is that QE2 cannot stoke inflation in the US, but causes very unwelcome interference in exactly the other places in the world where inflation is a big concern.

It's small wonder all the growth EM economies are engaging in the low-grade currency war of capital control. To them, this is a defensive war for survival against the invading army of dollars. If the low-grade war proves insufficient, they would escalate the defensive posture. They have to.

Another consequence, intended or not, of QE2 + reserve status is that all growth economies are under tremendous pressure of currency appreciation. Some may be able to resist it and muddle through until an easier day; others will have to cave in, therefore caught in the catch 22 of either raging inflation or shrinking economy, or both. And, of all the growth economies, China arguably has the most capacity and strongest political will to resist appreciation. In such a scenario, if the intended target of Fed's fury is China, as hinted not so subtly by Bernanke, "collateral damage" would once again be the main theme, as has been in all recent offensives launched by the US.

In summary, Fed's dogged efforts in stoking inflation have caused and will continue increasing the risk of bringing all growth EM economies to a halt, significantly increasing policy risks in the rest of the world as each country tries desperately to deal with the capital tsunami, and all the while with huge doubt in whether it could reach its domestic goal of stimulating employment and housing. In other words, Fed is screwing the world for a slim chance of helping the US economy.

This is emphatically NOT a moral criticism. But it does represent a significant abandonment of the responsibilities on Fed's part as the issuer of world reserve currency.

Let's go back a little in history. Right on the heels of WWII victory, in 1944 US dictated Bretton Woods that established the dollar as a proxy for gold in the free world. The "proxy" part was only convenience, of course, as to be expected and proven by Nixon in 1971. The arrangement made sense: the US would provide security blanket, and the rest of free world would pay for it by accepting and holding the green paper printed by the US. It's the same idea as gangs collecting protection fee in NY, no cynicism intended.

Fast forward to Berlin Wall collapse. Now the fundamental premises of the dollar's reserve status were gone. Europeans quickly realized this change and created the Euro; why should they continue paying for protection when there's nothing to protect against? The US has made numerous fantastic efforts in creating threats (by "creating" I don't necessarily mean create; often times you just have to doze off for a second and the enemy will help you out): perpetual terrorism, WMD in Iraq, perpetual war in Iraq and Afghanistan/Pakistan, Iran, North Korea, China, even Somali pirates (now it gets really pathetic). But none of them could ever live up to the high expectations set by USSR.

After 10+ years of trying, it's become clear that this is futile. Nothing works; none of those idiots could do it. But with the reserve currency status comes its responsibilities. Win-win is BS-BS; there's no free lunch after all. The time has come to end Bretton Woods II.

Now Zoelick's surprise proposal of a new gold standard makes perfect sense.

With QE2 the Fed is saying: Ah fuck it, you don't like USD as the reserve currency? Well guess what? We don't like it, either. So let's drop it and from now on it's every man on his own. Good luck.