Tuesday 31 March 2009
He Who Has the Gold Makes the Rules
Chinese central bank Governor Zhou Xiaochuan has a point when he said in a white paper only days before the G-20 meeting in London: “Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries’ demand for reserve currencies.”
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He Who Has the Gold Makes the Rules
Thomas Wilkins, Georgia
31 March 2009
Chinese central bank Governor Zhou Xiaochuan has a point when he said in a white paper only days before the G-20 meeting in London: “Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries’ demand for reserve currencies.”
He has captured the attention of the world, especially the US stock market which does not know how far China will push on this white paper at the London G-20 meeting. Does he want to downgrade the US dollar from the international monetary system? Can he really have a reserve asset which is stable? Can he really have a flexible asset that can expand when needed without expanding too much? Can he really get other nations to walk away from “credit-based” national currencies as reserves?
Before Governor Zhou’s white paper was released, the format of the G-20 meeting in London seemed destined to focus on the problems in the banking industry, how to stimulate the world’s economies with government spending and tax cuts and how to contain protectionist measures in face of rising unemployment. A full-blown monetary inquiry into the status of the US dollar as a reserve currency was not of the radar screens just two weeks ago. Zhou’s white paper has changed the orientation of the meeting. He has “the gold,” namely large reserves of US dollars and therefore holds a significant voice in how the Obama Administration will sell its deficits in the bond market. As a result of having this “gold,” the Chinese have the potential of a strong voice in making the rules.
But will the rules be golden? This dialogue is a dual edged sword. The US has the largest buying power in the world and so the Chinese can not make new rules unilaterally.
Readers of ChinaStakes were briefed with plenty of advanced notice in its November 23, 2009 article about Zhou connectiions at the highest levels of US policy. The article entitled “The Zhou-Geithner Connection” pointed out that Zhou is a member of the Group of Thirty. Also, a member is US Secretary of Treasury Timothy Geithner and Paul Volcker, former Chairman of the Board of Governors of the Federal Reserve System and now economic adviser to President Obama. This group is an informal clearing house of research and opinions concerning monetary affairs. It meets twice a year and publishes monetary papers.
The Group of Thirty has recently published its Financial Reform: A Framework for Financial Stability. This report began in July 2008 under a Steering Committee chaired by Paul Volcker. All of the members of the group had an opportunity to review the preliminary drafts. The theme of this report focuses on regulation issues at financial institutions which will is important to Governor Zhou’s concerns. But his concerns go further than regulations. His concerns are deeper.
In Zhou’s white paper, he is alarmed by the US Federal Reserve announcing at its last meeting that it intended to purchase US bonds. Many see this step in Washington as a way of “printing money” or monetizing the large US budget deficits. The fear is that this will lead eventually to more inflation which would, if it materializes, weaken US bonds owned by the Chinese central bank.
Another alarming statistic which obviously is bothering Zhou is the parabolic shape to the US monetary base, defined as the sum of currency in circulation and bank deposits at Federal Reserve Banks. In the time period right after the collapse of Lehman Brother and the end of 2008, the US monetary base increased from approximately $890 billion to $1.74 trillion. The bulk of this increase was caused by a rapid rise in bank excess reserves. Congress recently authorized the Federal Reserve to pay interest to banks on their reserves at the Federal Reserve. These reserves are mandated by the requirement for bank to hold 10% of checking account at the Federal Reserve. After the fall of Lehman Brothers, the Federal Reserve dramatically reduced the interest rate on Treasury Bills (see ChinaStakes, December 17, 2008 “The ‘Liquidity Trap’ Could Happen) and reduce their competition with interest-bearing reserves.
Many see a rapid rise in the monetary as a red flag for impending inflation. Chairman Bernanke in two recent speeches says this statistic can be reverse, when in his words the economy improves.
Governor Zhou’s white paper suggests skepticism in the Fed’s ability to reverse these reserves from leaving the books of the Federal Reserve and spilling over into the economy. The rapid and enormous expansion of excess reserves can go in two different directions.
“When” the US economy improves, these excess reserves will seek a higher rate of interest. At that time, the money multiplier will kick in and could increase the money supply many trillion fold.
On the other hand, if the economy stalls in a “liquidity traps” when lower interest rates do not stimulate demand for lendable funds, the banks will be receiving its best investment opportunity. Three month US Treasury Bills are close to zero percent whereas the risk-free rates of one fourth of one percent could perpetuate the “liquidity trap.”
The Zhou white paper shows the conflict in the current monetary system. On the positive side, US balance of payments deficits provide the world with liquidity and reserves for central banks. Before the breakdown of the Bretton Woods system when President Nixon closed the gold window, the world accepted the dollar as a reserve asset. President of Gaulle of France saw the weak spot and realized that eventually this policy of exchanging central bank dollars for gold would breakdown as the dollars were increasing at a faster rate than the production of newly mined gold.
As Zhou has described the problem a sovereign nation cannot be a servant to two masters. Namely, it cannot pump money into its domestic economy without this pump priming ending up in foreign bank accounts. And if the US stopped running balance of payments deficits, international economies would lose the additions of reserves which they need for growth.
Zhou’s solution shows respect for John Maynard Keynes, the leader of the British delegation at the Bretton Woods Conference after World War II. Keynes advocated an international currency that was fixed in terms of 30 commodities, including gold. Instead of choosing Keynes’ plan, the delegates chose a system based on the US dollar which was convertible into gold at $35 per ounce. When De Gaulle’s vision turned true and Nixon stopped the option of converting dollars held by foreign central banks into gold, the international system worked on money declared by governments to be legal tender. It was sometimes called “fiat money,” which derived from Latin “fiat” or “let it be done.” Fiat currency is fine if a citizen wants to pay his taxes to the government. The government accepts this payment. Fiat currencies after 1971 meant that a country could restrict or inflate its money supply without having to worry about gold. But as the Zhou white paper reminds us, there is a limit to the market accepting something as payment.
Governor Zhou’s white paper advocates a stronger role for the SDR; this is Special Drawing Rights at the International Monetary Fund. Instead of the bancor basket advocated by Keynes being based on commodities, SDRs are based on a basket of major currencies. Currently, 44% of the SDRs are made up of US dollars, 34% of Euros, 11% of Japanese yen and 11% of Great Britain Pounds. The architects say that the percent weights are derived from the relative importance of each currency in international trade and finance.
There will be a steep slope for the world to adopt SDRs for international payments and pricing as the SDR is used in only limited areas. For example, the Warsaw convention specifies the value of loss luggage by airline personnel or by accidents are valued in SDRs. They are also used by the International Telecommunications Union for transferring roaming charges for users inside one countries when they accounts are in another country. This a far stretch from pricing oil from the Middle East or copper imports into China.
What then are the chances that the Zhou white paper will be have an impact? Longer term, Governor Zhou is looking out over the valleys and mountains. He is like President Chairman de Gaulle. He foresees a weak spot. Will the US accept his proposals? Does he only want to bargain or does he want to “make the rules?” The international monetary system is so big that it will take significant bargaining to bring agreement on a new reserve asset, whether it is a basket of currencies or a basket of commodities or even an elevated role for gold.
Governor Zhou is right to be concerned about the rapid rise in the US monetary base. Perhaps, Chairman Bernanke can reverse the rapid rise in the monetary base and avoid its spilling over into the money supply. Governor Zhou has valid reasons to be concerned about the inherent conflicts of a sovereign nation using its currency to stimulate its domestic currency and causing its exchange rates to depreciate. He is right to see the world at a critical junction. Are we heading for super inflation or a devastating deflation?
While many will feel threatened by Governor Zhou, he is the De Gaulle of the 21st century and many will slowly recognize his insights into the conflicts of the current system. His suggestions will surely be discussed for some time, well after the G-20 meeting concludes. The deflationary pressures in the US economy will surely reduce many of the fears in his arguments about forthcoming inflation. Deflation is what the US central bank is afraid of, not inflation.
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