China and the International Dollar


Before the dollar there was the pound, and after the dollar there will be something else.

Today’s Financial Times’ articles: “Hu questions future role of US dollar”, “Why ‘Top Dollar’ Still Runs the World” and “Renminbi rolls out” (all January 16, 2011)

The problem we face today, as so often in matters financial, is that no one knows the future, that many futures are possible, and that the actual future is quite likely to be something not currently on anyone’s list of possibilities. In such a circumstance, we are well-advised to lower our sights, and to try instead to make sense of the present, to understand the current forces that are shaping the future we are unable to see.

In popular accounts of the current turmoil, attention has tended to focus on the renminbi-dollar exchange rate and the Chinese policy of keeping that rate more or less fixed. This “market friction” is condemned as a source of instability. “If only the Chinese would allow their currency to rise to its proper value,” the suggestion comes, market forces would be able to correct the global imbalances that beset us.

Maybe so, but maybe also not so. From a money view standpoint, one worries whenever an argument depends on treating the price of money as if it were analogous to the price of cabbages. From a money view standpoint, a fixed exchange rate is not the same kind of thing as a price support or ceiling on some basic commodity, against which Econ 101 warns us.

In the money view, the price of money has four different dimensions: par, the interest rate, the exchange rate, and the price level.

Modern economic discourse tends to abstract from par, perhaps thinking that par is a historical relic more relevant to a former era of mint parities when gold was exchangeable for currency. But par is a more general idea than that, expressing the price of one form of money in terms of another, as for example bank deposits in terms of currency. We are so used to withdrawing cash from our ATMs that it never occurs to us that we are trading one form of money for another, but so we are, and we would be rudely awakened to that fact if everyone at once tried to convert their deposits into cash.

More relevant for the present topic, foreigners got used to thinking of their accounts at Money Market Mutual Funds and their Eurodollar deposits in foreign banks as more or less the same thing as bank deposits in New York. But then the global financial crisis taught them otherwise when the Reserve Fund “broke the buck” and LIBOR traded at 100 basis points over Fed Funds.

Par is the price of one form of money in terms of another but usually, if we look closely, we find that one of the forms is better than the other; one is money and the other is a money derivative, a promise to pay money proper. In a crisis, the promise to pay is tested, which means that par is tested. How good a substitute for money proper is the money derivative?

All the talk about the future of the dollar can be understood in this light as speculation not about the domestic dollar but about the international dollar that trades (usually!) at par with the domestic dollar. This international dollar has, in the past, stood above merely domestic currencies in the hierarchy of money, but maybe not in the future.

A central fact revealed by the crisis is how much the world apparently still wants to hold dollars. Indeed, the rise of the shadow banking system can be understood in large part as the attempt by private profit-seeking bankers to meet the swelling world demand for dollar balances. And the enormous expansion of the Fed’s balance sheet during the crisis can be understood as an attempt to meet the same demand, by substituting money proper for the derivative shadow money that collapsed along with the shadow banking system.

Put another way, a central fact revealed by the crisis is that the international dollar is in fact a money derivative, and that the domestic dollar is money proper. When the shadow banks faced difficulty rolling over their short term funding in international money markets, the Fed could very well have refused to step in, and maybe next time it will.

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