The Hindu Business Line : US Fed needs global watch

After the Cold War ended, the US promoted globalisation in a big way. It opened its markets, cut tariffs and promoted cheap imports. The Fed also cut rates and printed more dollars. It thus promoted a global financial architecture by which an unwritten ‘safety rule’ has been enforced on central banks of other nations to hold their reserves in US securities. This structure is clearly unsustainable, argues S. GURUMURTHY.

First principles of monetary economics tell students why central banks are central to a nation’s economy. Central banks create money, the common tender without which no economy can function, and fix its price, namely, interest rates.

Applying this twin norm, is it correct to say that US Fed, which supplies the dollar to the central banks of other nations and decides at what rate it will lend dollars, is the de facto central banker of the world? The role of the dollar in the global economy will settle the response to this question. As reserve currency and as invoicing medium, as currency of investment and in forex transactions, the dollar issued by the US Fed dominates.

As per IMF data (2006) over 65 per cent of global forex reserves, (even 70 per cent plus in non-Euro areas) 41 per cent of global loans and 48 per cent of global deposits are held in dollar terms; 57 per cent of the US Treasury securities are held by Asian nations and 21 per cent by European nations; 53 per cent of US equities are held by Europeans, 26 per cent by Western hemisphere nations, 18 per cent by Asian nations.

Bank of International Settlements reveals that 43 per cent of all forex transactions are in dollar terms. Identical is global trade in dollar terms. The OPEC sells oil only in dollars. That the dollar as a currency is more global than a national, and as a central bank US Fed is more a global than a US entity, are manifest in one single fact. Namely out of the dollar stock of $800 billion created by US Fed from its birth in 1913 till now, only less than a third of it circulates in the US and more than two-thirds is exported outside the US.

This also confirms, as The Economist magazine derisively wrote some 15 years back, after the first Gulf War, that dollar printing press had become the most profitable business of US! So, non-Americans seem to need more dollars for business with and outside US, than Americans need the dollar for use in US or outside.

How did the dollar come to play this central role? In 1950s, thanks to the Bretton Woods formula, the greenback officially became the global currency. But, after the formula collapsed in 1971, the dollar lost its official status. But, for lack of an alternative, it became the de facto global tender.

With the end of the Cold War in 1991 the economic, political and military restraints and constraints it had imposed on the US eased. Moreover, the US emerged as unparalleled global power. Perhaps believing the scholars who counselled that the West — read the US — has finally emerged as the victor over the rest, the US, particularly the US Fed, went on a hype.

Globalisation, liberalisation

Convinced that its model had won finally and egged on by powerful global corporates, the US went gung-ho on globalisation and liberalisation of its economy. It also began exerting pressure on others, by itself and also through WTO, IMF, World Bank and the rest, to liberalise on its terms.

The US also took to liberalisation in a big way, mostly on domestic compulsions. The US government opened its markets, cut tariffs and promoted cheap imports. Matching it, the US Fed cut interest, printed more dollars. It printed an extra $400 billion in 12 years from 1996 to 2007, much more than it had printed in 82 years up to 1995. The idea was to provide cheap money to US households so that they could buy goods which cheap imports brought in. This combined agenda had had a telling effect. As US Fed cut interest rates from 8 per cent in 1990 to 1 per cent in 2001, the US households began spending beyond their income and their credit card debts shot up from $338 billion in 1990 to $2.46 trillion in 2007, even as their savings which was 9 per cent in 1990 turned negative in 2006.

The US current account deficit which aggregated to $300 billion for a whole 10 years from 1990 to 1999, jumped to $2.5 trillion for just five years from 2000 to 2004. Result: An indebted US government and indebted US households.

The dollar game

The unceasing cycle of the dollar game is like this. The Fed cuts interest repeatedly and US households slow, and then stop, saving.

The Fed digitally prints and supplies more dollars to enable the households to borrow and spend in malls. The malls import goods from China and elsewhere and sell them to the US households. The dollars created by US Fed and lent to households through credit cards fly to the countries exporting to the US.

The Fed brings the outbound dollars back, by borrowing them back from foreign governments, to bridge current account deficits. This borrowing by US Fed suits the foreign governments who, being always frightened of a situation like what East Asia faced in 1997, are compelled to maintain increasingly higher reserves in dollar form to defend their currencies.

The US Fed has, thus, promoted and supported a global financial architecture by which an unwritten ‘safety rule’ has been enforced on central banks of other nations to hold their reserves in US securities, very much like the Reserve Bank stipulation of SLR.

Whether the present reserves of $3.8 trillion is enough to assure safety no one can say. This is the dollar game in which the world, including the US, is caught like a bee that has fallen into honey pot! Is this global financial architecture sustainable? In one word, the answer is: NO.

But, how does the Fed see the unsustainable dollar game? Mr Ben Bernanke, now the chief of Fed and its Governor in 2002, could not be more open. He said “US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost.

By increasing the number of US dollars in circulation, or even by credibly threatening to do so, the US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” (emphasis not in original).

The context for this statement was that the Fed rate at that time was 1.25 per cent below which it could not cut any further. Mr Bernanke’s idea of printing more dollars even risking its depreciation, to sustain or increase consumer spending in US, only affirms what the Fed has been doing from 1995, and the result of it is the accumulation of $3.8 trillion outside US.

But was Mr Bernanke bothered about the consequences of his threat to reduce the value of the dollar to nations which hold such huge reserves? Obviously not. His mandate is only to “attain the basic objectives of US economy”, regardless of what happens to the global economy.

Decision-making

The Fed’s actions affect other nations, their currencies, their forex reserves and their valuation, their interest rates, and host of other monetary and non-monetary issues. But how does the US Fed take policy decisions on interest rates? On printing or threatening to print dollars and its timing and quantum?

This is what G. Edward Griffin, the author of The Creature From Jekyll Island: A Second Look at the Federal Reserve has to say on the unmonitored, secret decision making by the Fed: “Decisions are made at secret meetings. A brief report is release to the public six weeks later, but transcripts of the deliberations are destroyed. That policy was begun in 1970 when the Freedom-of-Information Act was passed. Not even the CIA enjoys such secrecy.”

Congressman Ron Paul, member of the House Banking Committee, had this to say about Griffin’s book “A superb analysis deserving serious attention by all Americans.” But actually it deserves serious attention by the whole world.

The President-led system in the US does not seem have the will nor political tenure long enough to correct the distortions in this informal financial rule setter of the world.

Its structure does not lend itself to political control. QED: Undoubtedly, the US Fed needs global watch, even a global watch-dog, as it seems to be answerable to none at home, including the US Congress.

(The author is a corporate adviser. His e-mail is guru@gurumurthy.net)

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