Key points
1.The world remains on US$ standard; there are no alternatives.
2.US$ remains the key driver of most macro variables but it is unforecastable
3.We are concerned that declining liquidity, attempts to raise rates & China’s hesitancy is a recipe for stronger US$. Turkey might tip it over.
‘It is our currency but it is your problem’; It is everyone’s problem
Victor Shvets writes….The Triffin paradox (formulated in ‘60s) states that a country issuing reserve currency must run ever-increasing deficits, or find alternative ways of injecting sufficient liquidity to lubricate global interactions. This is in turn places such a country into a difficult position of constantly trying to balance conflicting domestic and global agenda. It is not only a problem for issuing country but it is also a major headache for the rest of the world. Keynes was right when he suggested creating ‘Bancor’ as an independent global currency. This was unacceptable to the US in 1940s and it is unacceptable today, as it requires ceding domestic sovereignty. Connally was wrong; US$ is a problem for all.
Today, there is no alternative to the US$. Recent small-scale barter deals are a drop in the bucket. US$ continues to dominate trade, finance and reserves. No other country can replace US$, because a reserve currency requires: (a) large and liquid pool of securities; (b) to be freely exchangeable, with minimum restrictions; & (c) an issuing country must run deficits to inject enough liquidity to lubricate the global economy. Today only the US$ satisfies all of these conditions. Alternatives like gold or cryptos are either not yet ready for prime time or cannot expand at a fast enough clip to facilitate global financialization.
But, alas, currencies are largely unforecastable
Hence, US$ remains the most important global driver of key macro variables, from liquidity and inflation to demand. It determines how fast global economy can expand and it distributes gains and losses to various countries and asset classes. In most cases, expanding global economy and trade requires stable-to-weak US$, with direction and intensity being important. However, rapidly rising US$ strangles liquidity, creates disinflation and reduces demand. That’s why more is written on US$ than on almost any other topic, with pages devoted to charts showing LT sweeping trends or variety of fundamental factors, from REER to deficits, growth rates to spreads, alas, to no avail. Currencies are far too complex to forecast. But getting US$ wrong is deadly.
If not well-managed, there is a risk of rapid US$ appreciation
With that proviso, how do we look at US$? We have very simple formulae: abundant liquidity + low volatility + rising reflation = low US$ and in reverse, declining global liquidity + rising volatilities + declining reflation = rising US$. There is of course a question of causation, as US$ is responsible for liquidity or reflation, while also magnifying their impact. However, as public sectors are now aggressively managing cycles, it is state policy choices & settings that determine final outcomes. Today, CBs are reducing liquidity, and China is uncertain as to how robust it should become in reflating demand while monetary policies are more divergent, driving higher volatilities. Plus, we can add social & political factors. How much would US$ appreciate, if Turkey were to introduce capital controls & some repudiation of US$0.5 trillion of its foreign debt? The risks are high, and it is far from clear whether Trump & ECB can stabilize Turkey, leading to a potentially much wider contagion.