Opportunities in smallcaps header image 2


August 6th, 2008 · 1 Comment

In economics, this term refers to the ability to create money. It’s a nice ability to have. It’s even nicer to do it on a world scale. The US has had this privilege. But will it last?

First, the advantage to be the issuer of the worlds reserve currency have not always been very clear to everybody. A couple of issues:

  • It’s nice when you make debts to the rest of the world, you can pay them back in your own currency. Ask any developing country with substantial debts and they will agree. These debts will typically be in US dollars, and if the debt becomes difficult to service (or, if this is perceived to be so), then trust evaporates in your own currency, people flight from it, it plunges and the debt, in local currency terms, will explode. This is what happened in the Asian crisis and also to South American countries
  • However, if your debt is denominated in your own currency, and people start distrust the ability to service it or to pay it back (which they shouldn’t, because you can create unlimited amounts of your national currency), the value of that currency starts falling relative to other currencies, and hey, your debt is being reduced (this phenomenon is very similar to the ‘inflation tax’).

So, at first hand, it seems fantastic to be the issuer of the world currency. You can make unlimited debts, and if that starts eroding the trust in your financials, that debt will be reduced. You can also issue unlimited quantities of your currency to pay it back.

Now, although this might all seem pretty theoretical stuff, some of our more perceptive readers will no doubt have recognized a rather realistic scenario, one that is being played out on the financial markets on a day to day basis.

The US is the issuer of the worlds reserve currency. Basically, it’s debts are denominated in it’s own currency, the US dollar. Since it can print unlimited quantities of these dollars, there is little to stop it from doing, is there? Especially if you are a rather ambitious nation, like the US is, a world policeman.

Two decades before Paul Kennedy coined the term ‘imperial overstretch‘ (in ‘The rise and fall of the Great Powers), General de Gaulle of France complained about those US ambitions (at that time it was the Vietnam war, we will forget that the US actually originally substituted for the French, who made rather a mess of things there), and especially on it’s prerogatives of financing them by issuing great dollops of the world currency. It seemed like there was something like a ‘free lunch’ after all.

To be fair, the process is not entirely limitless, even for the issuer of the world currency. Other nations receiving those dollars (which the US spend beyond their means) will put them in US government bonds. The Chinese and Japanese have put a great deal of their national savings in these.

Interest has to be paid on these bonds, and when the financial situation gets more shaky, and confidence in the finances of the issuer of the world’s currency wanes, these interest rates will have to go up.

But the process does describe that the constraints for the US are less compared to those for other countries, and America has taken to these opportunities with abandon, living beyond their means for a couple of decades now and issuing large amounts of dollar denominated debts in exchange.

This has started in the 1960s with Johnson’s ‘Great Society’ social programs and especially with the Vietnam war under Nixon. This has led to the US having to sever the link between it’s currency and gold, and the subsequent explosion of the Bretton Woods fixed currency system.

It has led to another financial crisis in 1987 when the dollar steadily eroded in value because of the Reagan tax cuts (it had to be shored up by the Plaza agreement in 1985).

But no government has eroded the state coffers with such amazing speed as the current one, Having both a costly war and substantial tax cuts, the erosion in the public finances is breath taking, and the printing presses are working overtime to keep the financial system afloat.

Countries can already issue debt in euro, so there is an alternative emerging. With each financial crisis, the US’s role as the issuer of the world’s currency is further eroded.

Tags: The Markets

1 response so far ↓

  • 1 Can the US go broke? // Aug 23, 2008 at 10:55 pm

    […] is denominated in their own currency (we wrote about the advantages of ’seiniorage’ here), of which they can print unlimited amounts (in principle, but there are countries who actually try […]