I stumbled upon this article from 2010 at Business Insider. It turns out, the article was republished at Business Insider; the original posting was at NewDeal20.org, a now defunct website. The article though, is very interesting, and worth examining.
The author talks about a story published by former Treasury Secretary Hank Paulson in his memoirs titled, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System.
In the summer of 2008, the Beijing Olympics were taking place. Hank Paulson was there. At the Olympics, he heard from a Chinese official that,
“Russian officials had [earlier] made a top-level approach to the Chinese suggesting that together they might sell big chunks of their GSE holdings to force the U.S. to use its emergency authorities to prop up these companies.” Paulson said while “the Chinese declined to cooperate”, the report was nonetheless “deeply troubling,” as “heavy selling could create a sudden loss of confidence in the GSEs and shake the capital markets.”
Hank Paulson got worried when he heard these rumors. His worries revolved around the fact Russian and Chinese selling would amount to economic warfare, at a time when the US was very vulnerable.
It turns out, the rumors were true. The Russians and the Chinese did sell their agency debt (Fannie Mae & Freddie Mac) holdings. The Chinese only sold $60 Billion. You can see from the below chart form the Council on Foreign Relations that the $60 Billion barely made a dent in China’s holdings of US assets.
The Russians liquidated all of their GSE holdings, about $160 Billion worth.
The US was forced to nationalize Fannie Mae and Freddie Mac. It’s entirely plausible that the foreign (Russian and Chinese) selling of agency bonds was the reason the US government had to intervene. With that said, as we mentioned earlier, the GSE’s are now cash cows for the government. The bonds that Russia sold, have since skyrocketed in value.
So the question becomes, is there a danger that China will sell it’s US assets as part of the brewing Trump trade war, as a way of driving down US asset prices? The answer to that question is simple: NO.
First, China’s holdings of US assets, from agency debt to corporate and Treasury bonds, have gone down quite a bit since they peaked in 2014-2015. The reason is that China had its own domestic financial crisis in 2015; Chinese asset prices crashed in value, and the government was forced to sell to raise cash.
In response to the crisis, the US Federal Reserve simply increased Quantitative Easing; anyone who wanted to sell US assets, specifically GSE agency bonds or US Treasury bonds, the Federal Reserve was a willing and ready buyer, with very, very deep pockets. How deep? Lets just say the Federal Reserve is the only entity on the face of the Earth than can create money out of thin air. The Federal Reserve can print money at will!
The chart below shows how the result of this. It shows the value of assets that the Federal Reserve holds. Those assets are primarily US Treasury Bonds and Fannie Mae/Freddie Mac GSE Agency Bonds. It bought from any and all sellers, and printed US Dollars to pay for them.
So the question then becomes, how is the US able to do that? The reason is because of something called Dollar Hegemony. I’ve linked a Google search there, because the topic is one we can spend a lot of time on. Dollar Hegemony is defined as follows on Wikipedia:
“A state’s access to international credits, foreign exchange markets, the management of balance of payments in which the state operates under no balance of payment constraints, and the direct power to enforce a unit of account in which economic calculations are made in the world economy.”
Translated, this means that,
- The United States, with its currency, the US Dollar, can borrow money from anyone in any corner of the world. It is not restricted or shut out from any credit market. Why does the US have this ability? Because the US Treasury has guaranteed to all creditors, all over the world, that the “full faith and credit of the US government” stands behind every debt it owes.
- The US Dollar is, “legal tender for all debts, public and private”. These words are written on all currency printed by the Federal Reserve. Those words guarantee that there will always be a demand for US Dollars because the US Judicial system stands behind its use for paying debts. Simply put, in every corner of the world, everyone knows that the US Dollar’s value is guaranteed, and therefore in every corner of the world, people will accept the US Dollar in exchange for anything, whether it be goods, services, or other currencies.
- The United States operates under no balance of payment constraints. What does that mean? It means the United States can run an unlimited tab. Why? Because it has the ability to finance its liabilities via the dollar denominated debt markets. They are the largest and most liquid in the history of the world.
What does this all boil down to? Well, think about the predicament that Turkey is in today. It is at the mercy of foreign creditors because it borrowed money in US Dollars and Euros; it borrowed money in a currency other than its own. Turkey owes money to foreigners, denominated in a foreign currency. This makes them susceptible to everything foreign, things they have zero control over. From the US Dollar interest rate to the US Dollar exchange rate, Turkey is powerless. The only thing it can do is beg; India’s central bank governor actually did just that recently in a Financial Times opinion piece. India also has a lot of dollar denominated debt.
The countries most exposed to foreign interest rates and US Dollar strength due to foreign debt liabilities are Argentina, Turkey, India, South Africa, and Ukraine.
In the case of the United States, it has neither of these issues. All debt the US government issues is US Dollar debt. There is no such thing as foreign debt, even though foreigners own a lot of US debt. The US has complete control over all it’s debt, even as a borrower.
When you can convince a foreigner to use your currency, he/she becomes invested in the livelihood of that currency, and everything that backs it. China, which owns over $1 Trillion of US Dollar denominated treasury debt, has no interest in the decline of the US Dollar. This is the power of the reserve currency. The Federal Reserve can print as many US Dollars as it wants because the US Dollar has proliferated the world because the entire world is in bed with King Dollar.
It can be said that China, even more so than the United States, is interested in a strong US currency. By extension, it is also interested in a strong US government and economy, as those things back the full faith and credit of the United States.
Here’s another interesting point from Newdeal20.org:
“The U.S. is never in danger of defaulting on its sovereign debt because it can print all the dollars necessary to pay off foreign holders of its debt. There is also no incentive for the foreign holders of U.S. sovereign debt to push for repayment, as that will only cause the U.S. to print more dollars to cause the dollar to fall further in exchange rates.”
The above essentially means that even if things got bad and the “full faith and credit” of the United States somehow was challenged, foreign owners of US debt would have no incentive in forcing repayment. Forcing repayment would only force the Federal Reserve to print money, which would create inflation and drive down the value of the debt owned by, foreign holders, like the Chinese. The Chinese would be shooting themselves in the foot! The more likely situation is that the debt would be renegotiated; once again, advantage US.
Newdeal20.org continues by explaining the unique status of the US Dollar as the world’s reserve currency:
“…dollar hegemony, a peculiar condition in global finance in which the dollar, a fiat currency that the U.S. can issue at will, is recognized worldwide as a reserve currency for international trade because of U.S. geopolitical power with which to force the trading of critical basic commodities to be denominated in dollars. Everyone accepts dollars because dollars can buy oil and every economy needs oil. Granted, one can buy oil also with euros and yen, but only because these currencies are freely convertible to dollars, and therefore they are really derivative currencies of the dollar.”
Notice that the above excerpt basically rephrases the bullets we discussed above on “Dollar Hegemony”; the US dollar is essentially the new Gold. The only currency in the world that has a surely defined value is the US Dollar. This is what Reserve Currency means. All other currencies derive their value from the US Dollar; the dollar is the benchmark currency.
So where is the catch??? So far, things are working out fairly well, thanks to the US Navy. Wait, why the US Navy? Because the US Navy protects international trade and commerce. There is a reason why the US Navy has more aircraft carriers than the rest of the world combined. The US Navy is the guarantor of trade, worldwide. The US Navy protects the trade routes that move trillions of dollars worth of goods every year.
Why is that? Because about 62% of that trade is conducted in US Dollars. Without trade, the US Dollar’s value diminishes because demand for it goes down. There is some worry of that now, as a result of the US-China trade war, as evidenced by this recent opinion by JP Morgan published at Bloomberg.com. The below pie graph shows the breakdown of Foreign Exchange reserves, by currency. This is a proxy for currency exchange conducted in the course of international trade. Central Banks hold most of their reserves in US Dollars because it is the currency most in demand by companies and individuals involved in international trade and commerce.
But back to the catch. Because there is one. We are witnessing it today, in 2018. The reason why Donald Trump got elected on his Populist platform is because there is a side effect to the Dollar Hegemony. The proliferation of the US Dollar has enabled the US to control the flow of capital, even when the US is not a counterparty in the transaction.
Sanctions are a perfect example of this. The US can control commerce around the world, and restrict countries around the world from doing business with enemies of the United States, solely because the US Dollar is dominant reserve currency. The US is able to control where and how the US Dollar is used, especially in of commodity transactions. Think crude oil and the sanction reinstated against Iran.
Because the US Dollar is used and accepted in countries all over the world, US companies have the unique to tap international markets with ease; the US Dollar does the talking for them. This means they are able to seek out cheap labor markets. In addition, foreign countries have opened their doors to any company bringing US Dollars to the table. The more US Dollars those countries have, the stronger there domestic currencies are, and the more power they gain on the world trade stage.
As a result, countries all over the world bid on labor and manufacturing. US companies have the pick of the litter. This is why China, India, Vietnam, Mexico, and other developing countries around the world are now the exporters of products manufactured by US companies, overseas. The cheap labor in those countries pushes prices down, and margins up. This leaves American labor unable to compete; this is the side-effect, the American worker is priced out of the labor market.
This is why the US runs a gigantic trade deficit with China. It’s so much cheaper to manufacture in China, and then export that product to be consumed in the US. Not only does this deflate the price of goods, it also deflates the price of labor. Even if Chinese labor was to get more expensive, plenty of other developing countries would be more than happy to fill the gap. All in the name of attracting US Dollars.
The issue with Dollar Hegemony is therefore, deflation. The reserve currency status of the US dollar, its safety and security in any and all transactions, guaranteed by the US government, opened the door for its use in every corner of the world. Demand for the US Dollar is a force that feeds upon itself. When the entire world competes for US Dollars, they pay less and less for it.
Unfortunately, prices in the US have been deflated so much that the government has intervened, trying to force inflation. But it’s a futile task, because there are still pockets in the world where capital will flow before it comes back to the United States. Trump’s tariffs are trying to make foreign products more expensive, so that capital will find value in the US, but before capital comes to the US from China, it will go from China to Vietnam, to India, to Cambodia, to the Philippines, and so on, and so on, until US Dollar inflation abroad equalizes the playing field for US labor. Basically, until foreign countries demand more US Dollars for their services, US domestic labor can’t compete.
Confused?? Think of it this way:
- Imagine 4 countries: Country A, Country B, Country C, and Country D.
- Country A is the supreme power in the world (the United States)
- Country B, C, and D are poverty stricken countries.
- For Factory F to make product P in Country A, it costs $10.
- For Factory F to make product P in Country B, it costs $5.
Clearly, in the above scenario, Factory F leaves Country A and moves to Country B. Suddenly, the economic value of Country B skyrockets. People have new jobs, and more money than they could have ever imagined.
- Upon hearing that Country B got Factory F to move, Country C calls Factory F and tells them, we will make your product for $4.
- Factory F is astonished. It doesn’t want to move again, but says that it will build a new factory, a sister Factor, call it Fnew, in Country C.
- Suddenly, Country C, not only gets jobs to make product P, it also gets a whole bunch of jobs to build Factory Fnew.
- The next thing Factory F does is call Country B and tell them they need to lower their price for Product P, or else they will move entirely to Country C.
- This forces Country B to lower their price for product P to $3.50. It’s not as good as $5, but better than no factory at all.
Do you notice what is happening? With each new Country that finds out about Factory F, and Factory Fnew, a price war occurs; prices therefore come down. This is deflation. Many countries exist that are willing to do anything for jobs; this means the supply of labor is large, and so demand (factories) pay less and less for it.
Two things that will raise prices for product P:
- all viable labor has been lifted out of poverty,
- or labor demands higher prices. This happens through labor unions, and labor organization.
This has happening in China in the past decade; therefore, companies have opened up new operations in Bangladesh, Vietnam, Laos, Indonesia, etc… instead. Once labor prices rise in those countries, then other countries will step up to the plate, until prices have risen enough in all factory viable foreign countries. At which point, US factory labor can once again be competitive.
Another thing that would make US labor competitive is the elevation of transportation costs. That briefly happened in 2008, but since then, the shipping industry saw prices collapse, and they have not fully recovered yet. This is another headwind for US labor.
So in the end, just as Trump is competing to make US companies repatriate their assets to the US, developing countries around the world will compete for that capital also. Unless Trump plans to place tariffs on every country that capital could potentially flow to, the task is futile.
This is the side-effect of Dollar Hegemony. The side-effect is potential unrest in the working class stripped of the standard of living it once had. But the fact is, that standard of living came at the expense of extreme poverty somewhere else.
The free-flow of capital defines capitalism; the US dollar proliferated capitalism. At this point, we just have to deal with the side-effects until inflation levels the playing field.