Truth and Beauty: on the collapse of the world’s other monetary zone

This is a follow-up to my post about the possible breakup of the European Currency Union. There is a far more likely and significant change coming in the global currency system, described in this excerpt from the 7 July 2008 issue of Truth and Beauty, by Eric Kraus (an American expat living in Russia).

The Death of the Global Central Bank

The standard criticism levied against the Euro is that it necessitates a single interest rate to be set for two dozen highly divergent economies, and that at any given time, the monetary policy required for the proper function of the German and Dutch economies may be inappropriate for, say, Spain and Italy.

It is extraordinary that a far greater bit of economic insanity has apparently been overlooked – the “effective dollar-zone” which now subjects an infinitely more divergent group of countries – China, Hong Kong, Mexico, Qatar, Saudi, Venezuela, Ukraine, (to some extent) Russia, etc. – to a monetary policy set by the US Fed. Furthermore, whilst the European Central Bank has at least a mandate to set rates in the theoretical overall interests of all members of the Eurozone, as is perfectly logical, the US Fed is mandated by law to set rates in the interests of a single country – the United States. This is now creating economic havoc in numerous emerging countries with dollar-pegged currencies.

… Faced with shrinking domestic demand and the dire state of the US financial sector, the Fed may well be justified in pouring liquidity into a rapidly decelerating American economy. Unfortunately, given the fluidity of the global financial system, a large proportion of this newly created liquidity simply leaks into the fast-growth CA-surplus economies – which are in dire need of monetary tightening, rather than of a further flood of dollars.

The havoc he refers to is inflation. The US needs low interest rates as it slides into recession and deleveraging (aka defaults on debt, a deflationary force). These rates are far too low for the rapidly growing emerging nations in the dollar-zone. Artificially low rates cause inflation as night follows day. With rates far below the rate of inflation, this monetary stimulus causes their economies to run even faster – white hot — driving inflation even higher.

Unfortunately, the central banks choosing to stay in the dollar zone (aka the “Bretton Woods II system”) have few other options — as Kraus explains below.

Monetary Policy – The Fire this time – Globalization’s Rainbow

The globalization of financial markets has dangerously limited the ability of national central banks, inter alia the Chinese and Russian monetary institutions, to control their domestic money supplies by classical means – interest rate hikes and currency appreciation. Capital controls have been abolished in Russia while their efficacy has been seriously weakened in China.

Thus, a hike in domestic interest rates by a given Central bank simply attracts a flood of foreign hot money, exacerbating excess liquidity. At the same time, given their access to global money markets, local commercial banks can neutralize their higher borrowing costs by the simple expedient of borrowing cheap dollars abroad, thus making an end-run around their Central banks. Dollars borrowed by the commercial banks are promptly converted into the national currency and lent on to domestic clients, allowing the banks to capture both the domestic and the cross-currency spreads, secure in the knowledge that the ineluctable appreciation of these currencies will further increase effective lending margins.

Complicating the task of EM central banks, the expectation of gradual currency appreciation simply fuels the willingness of domestic entities to borrow in dollars, exacerbating the increase in domestic liquidity.

We thus suspect that the central banks of the countries running current accout surpluses have come to the conclusion that they may have to live with high inflation, not out of any moral failings, but simply because the classical disinflationary mechanisms available to them have become counterproductive. It is left to the finance ministries to control inflation by fiscal means alone – and a super-restrictive fiscal policy can be extremely costly, both in terms of lost growth and of political resistance to running huge budget surpluses in the presence of substantial unmet social needs.

The ideal solution from the standpoint of the EM economies would, of course, be a sharp rise in US interest rates and dollar parities – alas, they are very unlikely to see either. Thus, at least on the Russian side, monetary policy has recently been reduced to expressions of the hope that a slowdown in growth in global commodity prices would pull the chestnuts out of the inflationary fire; given the status of the dollar, more an expression.

… Whilst the inflationary burst in the emerging markets is neither “healthy” nor “good”, it is an arguable proposition that it may be best characterized as “inevitable” – with inflation most severe in those countries still clinging to the dollar currency peg.

Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about this subject

  1. A brief note on the US Dollar. Is this like August 1914? (8 November 2007) — How the current situation is as unstable financially as was Europe geopolitically in early 1914.
  2. The post-WWII geopolitical regime is dying. Chapter One (21 November 2007) — Why the current geopolitical order is unstable, describing the policy choices that brought us here.
  3. We have been warned. Death of the post-WWII geopolitical regime, Chapter II (28 November 2007) — A long list of the warnings we have ignored, from individual experts and major financial institutions (links included).
  4. Diagnosing the eagle, chapter I — the housing bust (6 December 2007)
  5. Death of the post-WWII geopolitical regime, III – death by debt (8 January 2008) – Origins of the long economic expansion from 1982 to 2006; why the down cycle will be so severe.
  6. Geopolitical implications of the current economic downturn (24 January 2008) – How will this recession end? With re-balancing of the global economy, so that the US goods and services are again competitive. No more trade deficit, and we can pay out debts.
  7. A happy ending to the current economic recession (12 February 2008) – The political actions which might end this downturn, and their long-term implications.
  8. What will America look like after this recession? (18 March 208) — More forecasts. The recession might change so many things, from the distribution of wealth within the US to the ranking of global powers.
  9. The most important story in this week’s newspapers (22 May 2008) — How solvent is the US government? They report the facts to us every year.

Originally published at Fabius Maximus and reproduced here with the author’s permission.

3 Responses to "Truth and Beauty: on the collapse of the world’s other monetary zone"

  1. JBOSS   July 30, 2008 at 2:23 pm

    I really don’t like the common tendency of confusing high and stable inflation with accelerating and unstable inflation.High and stable inflation (let’s say a target band between 10% and 11%) is not distorting vital price mechanisms, if it is well communicated, controlled and credible.Unstable inflation leads to a whole lot of inefficiencies, effectively disappropriating uninformed holders of currency (something that happened to my family’s fortune in the Germany of the 20ies).Extremely dangerous is obviously a runaway feedbay loop of accelerating inflation.A readjustment of the inflation rate target in countries with fixed exchange rate to the contrary is nothing but a currency appreciation in real terms, albeit one that doesn’t give a profit opportunity to hot money.Actually it really hurts them.Of course it undermines the status of a given currency as value storage, but this is a non-essential property of a currency (it keeps down your interest rates a bit if you have it though). The essential one being a reliable, neutral transaction medium that enables price discovery (preferably buffered from external shocks).In the case of the rupee and especially the Yuan it seems to me the aspect of value storage is not too valuable (Indians don’t trust cash anyway), especially since value storage could be provided by something like TIPS.Price distortion could be managed by a credible communication strategy. Of course once the target is reached the monetary brakes still have to be applied, but the problem of hot money flows counteracting official policy would be minimised.

  2. RL   July 31, 2008 at 5:55 am

    "Unfortunately, the central banks choosing to stay in the dollar zone (aka the “Bretton Woods II system”) have few other options — as Kraus explains below."I disagree. They can simply let their currencies appreciate against the dollar, which they should have done while ago and the mess wouldn’t be this big. Eurozone countries can’t do the same. It is true that many are doing it now, but it seems to be too liltle too late.RL