Frank Warnock on Two Myths about the Dollar

Frank Warnock, an expert on US capital flows and stocks, has just written a piece for CFR entitled Two Myths About the U.S. Dollar. In it, he examines “two factors that could substantially alter the long-run value of the U.S. dollar: the dollar’s reserve status and the sustainability of U.S. international debt.”

From the policy conclusion:

On the dollar’s reserve status, the
weight of evidence from U.S. data indicates that foreign governments’ purchases of U.S. Treasury bonds remain
robust, quotes to the contrary notwithstanding. To be sure, IMF data suggest that reserve managers’
views toward the dollar appear to have changed in the past few years. Until 2007, while valuation effects decreased
the share of dollar assets in reserve managers’ portfolios, new reserves were overwhelmingly placed
in dollar assets. Since then, the euro has become an equal, if not greater, recipient of new reserve flows. How
managers will react to the eurozone debt crisis is not clear. What is clear is that even after a decade of declining
value and increasing talk of the need for alternatives, Jim Rogers and other investors who acted in the expectation
of a near-term tipping point have so far lost money on their call. One reason is the powerful advantage
U.S. capital markets have over foreign rivals. U.S. treasuries—for which the market is large, homogenous,
and liquid—are still the world’s risk-free asset.13 But in the future there will be rivals in terms of market
depth and liquidity. To remain the world’s reserve currency, with all the associated perks and duties, the United
States must provide the world with both a stable currency not eroded by inflation and conditions, including
deep and transparent markets, in which outsider investors (be they domestic or foreign) are comfortable
committing funds. If the United States does this, the longer-term prospects for the U.S. dollar, while uncertain,
should be promising.

On the other hand, analysis of the sustainability of the U.S. current account and net international debt position
indicates that there is no silver bullet. U.S. investors do not have some exorbitant skill that would make
our international budget constraint any less binding. When the United States does run a current account deficit
and hence (on net) borrows from abroad, it must expect to have to service that debt—and it cannot meet
those payments by generating outsized returns on its foreign portfolio. In consequence, to the extent that the
United States continues to borrow, it must consider how it uses those funds. Borrowing to finance consumption
(whether public or private) is not sustainable. Borrowing to finance the expansion of the capital stock—
improving the economy’s productive capacity—is more benign. This isn’t a statement about the way foreign
capital enters the U.S. financial system. Foreigners may choose to buy mortgage bonds or they may choose to
buy equities; given the right policy framework, the financial system should be able to move the money such
that the extra expenditure financed by foreign capital goes on investment. But it is up to the government to
get the policy right. For too long, tax and other incentives have favored too much spending, too little saving, and too little investment. To prevent the U.S. dependence on foreign finance from ending painfully, this imbalance
must be corrected. Otherwise investors may lose confidence in the dollar, triggering an unwelcome
American version of competitive devaluation.

The paper is chock full of statistics and graphs. I like in particular Figure 3, which provides insights into China’s holdins of US Treasury securities, and reminds us of the pitfalls in using TIC data to infer holdings.


Figure 3 from F. Warnock, “Two Myths About the U.S. Dollar” (Council on Foreign Relations, 2010).

17 thoughts on “Frank Warnock on Two Myths about the Dollar

  1. Ricardo

    Do not miss the connection between the two “myths.” The US with the dollar as the world reserve currency can force its inflation on the rest of the world. What this means is that while a country can inflate out of domestic debt it cannot inflate out of international debt becasue the world is essentially on a dollar standard. Countries still have to essentially pay other countries in dollars as long as the dollar is the reserve currency.
    But this is a huge incentive for the US government and monetary authorities to inflate the dollar. The US through inflation can reduce both domestic debt and international debt. It is this aspect that causes China (and other heavy investors in US bonds) so much concern.
    The link between these two “myths” is strong and US economic authorities, with their arrogance, greed, and hubris, could bring down the US monetary hegemony with a crash.

  2. W.C. Varones

    “For too long, tax and other incentives have favored too much spending, too little saving, and too little investment. To prevent the U.S. dependence on foreign finance from ending painfully, this imbalance must be corrected. Otherwise investors may lose confidence in the dollar, triggering an unwelcome American version of competitive devaluation.”
    Ding! Ding! Ding! Give the man a cigar.
    You know what would accomplish that? Replace the income tax and capital gains tax with a consumption tax and abolish the Dirty Fed.

  3. Ekim

    Yes, abolish the Fed. The Fed promotes spending, discourages saving, and causes mis allocation of capital. Go to Milton Friedman’s advice to use a computer to expand the money supply by 2% per year, just enough to keep up with population changes.
    Discretionary policy has led to wild swings in monetary expansion. The committee has unfortunately proven conclusively that it cannot centrally plan the economy efficiently via the printing press.

  4. markg

    Without spending there is no investment. Do capitalist invest in new production if there is no spending to buy the output? The only way to maintain spending (to promote investment) and save at the same time is for the govt to run a deficit. Govt deficits equal private sector savings – right Menzie? Of course, you could save by running a trade surplus, but not every country can do this at the same time. Other countries want to save in US dollars so they run a trade surplus with the US to accumulate dollars. The US does not borrow from them, they save in US currency.

  5. don

    The problem is, much of the U.S. foreign debt is not drawn in by domestic borrowing demands, but pushed in by official currency interventions. These may have amounted to some $4 trillion since 2000, of which the U.S. got a large share. These official inflows are equivalent to someone putting money into your checking account without your permission (in fact, in direct opposition to your stated wishes), then holding you to the ‘loan.’ Japan reacted as one might expect when China did this to them. Why the U.S. is so understanding about such measures is a question I can’t answer, except to point to the interests of multinational companies.
    It is true that the mix of U.S. policies can influence whether the funds go to domestic investment, domestic consumption, or are merely intermediated and on lent to foreign borrowers. But there are limits to such influence. IMO, after the dotcom bust, domestic business didn’t want the funds, and U.S. financial institutions still remembered the LDC debt crisis of the early ’80’s and foreign savings were abundant (AD was already deficient globally), so the savings went to a domestic housing bubble. Cheap capital caused assets to appreciate and consumption demand to grow in tune with the increases in perceived wealth. This was a ‘virtuous cycle’ while it lasted, with pundits claiming loans from China were helping support U.S. housing and therefore U.S. consumption and U.S. GDP.
    The housing bubble has collapsed, but currency interventions continue apace. This has got to be stopped.

  6. don

    I should have added to my analogy – the person putting the funds in your checking account will not allow you to simply return the money to them, nor can you put the money into their checking account – they don’t have one (non-convertible currency).

  7. sherparick

    To the two posters above, all I can say:
    “For every complex problem there is an answer that is clear, simple, and wrong.”
    H. L. Mencken
    Admittedly, the track record of the Fed (and the other central banks the last ten years has not been something to brag about. The bubble denial about housing was something to behold and not knowing the the threat the eventual bust posed to both the visible and shadow banking systemsgiven that he safety of the banking system is one of the Fed’s prime responsibilities was something to behold and was grossly incompetent. But is not what you guys are worried about. You are worried that the dollar will fall 50% in value against the Yuan and about 30% against the Euro and Yen, which would make you only half the millionaires you currently are since most of your assets are valued in dollars. But of course, given the chronic current account deficit of the last 30 years it is obvious that the dollar is over valued. That is why your hero Milton Freidman championed floating exchange rates, so that currency adjustments would would correct trade imbalances without conscious human intervention. You guys worry about inflation when the problem of the moment is the the demand for money is so strong and the demand for goods and labor is so weak.

  8. W.C. Varones

    What you say about the overvalued dollar is true, but none of that justifies putting the money supply in the hands of dangerously incompetent central planners.

  9. Steven Kopits

    WC –
    I would not want to get too enthusiastic about VAT. I lived in Hungary for a good while–VAT of 25%. That means certain things really aren’t sold (or more precisely, bought) there: good clothing, jewelry, electronics. For these, you drive out to Slovakia or fly to New York and bring them over the border. VAT distorts trade.
    In my opinion, what matters is govt spending in GDP. If it’s low, taxes will be tolerable in whatever form. If it’s high, taxes will be high, in whatever form. It is the substance, not the form, of taxes that matter.

  10. W.C. Varones

    Steven Kopits,
    Agreed that level of taxes is more important than type of taxes.
    But if I’m going to drive consumption overseas or labor and investment overseas, I’ll choose consumption.

  11. Brad

    “It is this aspect that causes China (and other heavy investors in US bonds) so much concern.”
    The Chinese should have thought about that before they spent decades puffing up an economic model predicated on exactly the dynamics that now worry them.
    “The link between these two “myths” is strong and US economic authorities, with their arrogance, greed, and hubris, could bring down the US monetary hegemony with a crash.”
    Either the U.S. has “the” reserve currency (and/or is “the” superpower), or it’s a complete has-been. Got it. There can be only one.
    I was pleased to see this paper address these common failures of logic, but that apparently has no impact on those who think in binary.

  12. Lord

    An alternative to the dollar requires a large economy that is willing to borrow extensively. No such alternative exists. I am not certain any will ever exist. Euro borrowers have little input to Euro creation and as a result will always be precarious. Commodity speculation is about the only alternative but a risky one.

  13. purple

    There is no alternative to the dollar, but the US can’t support it anymore. Private sector investment will continue to bleed overseas and unemployment will remain high, domestic demand weak. The remedy for that is fiscal policy which won’t happen. The global financial architecture is shattered and we will limp along for years until it collapses entirely. In the meantime, enjoy life.

  14. Cedric Regula

    I can suggest one solution that foreign governments do to me. When they don’t want foreign inflows, they tax foreign investment.
    So the problem isn’t so much that we have a central bank(the fact they’ve gone insane is still a problem)but that our Treasury doesn’t want to tax our foreign central bank buddies. It may be that that not taxing them is another fundamental reason we are the reserve currency, I’m not real sure about it from that standpoint.
    But we push US money out of the country if you want better risk adjusted returns (this was called Dark Matter before global GR1)than you can get in treasuries or most anything else USD denominated. (except gold and silver lately)
    So I’m up for something different. Tax the foreigners and let interest rise so US money stays here and see if foreigners go away!
    Economic Armageddon? Dollar too strong for US exporters? Lets try tariffs instead of killing the dollar to the point that oil exporters really give us something to worry about. Let’s keep the domestic market for ourselves, and let Silicon Valley, MSFT and Boeing worry about a strong dollar, they can handle it. If the tariffs do reduce the trade deficit that is one component of dollar strength.
    Problems for housing valuations? Right now we are trying to figure out if you own the house you bought and whether the drywall will kill you, so the price is now secondary.
    I’m scaring myself. I think I’m turning communist.

  15. westslope

    I cannot imagine some kind of sudden devaluation of the US dollar. As the global economy continues to recover, capital will flow out of the US to new opportunities. This good news development will cause the US dollar to decline. But the decline should be slow and steady as I would expect the US to simultaneously grow at higher real rates.

    The real risk is the gradual erosion of material living standards. This will happen slowly enough that most Americans will fail to recognize the development.

    The serious problems are to be found in the West Bank, Gaza, Iraq and northern Pakistan. Presumably these expensive bloody civilizing missions are investments in the security and material well-being of all Americans. Borrowing money for these investments in arid land, religious monuments, and supposedly cheap, abundant oil is supposed to make good social sense.

    But does it? America is now the premier terrorist nation state in the world and her citizens are at each others’ throats. One might think that the opportunity to develop and practise the Obama Drones on live targets in northern Pakistan would instill enormous confidence in the American citizens. It doesn’t seem to be working.

    As many Americans believe in the right of every citizen to carry firearms for personal protection, you would think that the collapse of the anti-nuclear proliferation regime would make these Americans at least feel increasingly more secure. That doesn’t seem to be the case. Maybe they instinctively realize that owning a concrete bunker and being a 100kg overweight is still no protection against the fall-out of regional nuclear war?

  16. rayllove

    Considering that bubbles are, in essence, impossible without too much investment in regards to the volume of investment flows… this, from the post is wrong: “For too long, tax and other incentives have favored too much spending, too little saving, and too little investment.”
    Since The Economic Recovery Tax Act of 1981, wages/incomes have not been able to keep pace with capital formation. Perhaps if China and India and others would have allowed short-term inflows things would have balanced out as capital generated in the US would have had more opportunities to pursue. But the notion that emerging nations would need foreign capital when they have the ability create capital on a keyboard, without having to share their demographic dividend, well, that just shows how little understanding existed, and still exists, regarding fiat currencies and the ability to generate growth without capital. Much of what is wrong with the world stems from the unwarranted importance that financiers have given to themselves. But the truth is revealing itself and the nations that have put too much faith in their financial services sectors are in a race to the bottom. It is what they deserve, not just for being fat and lazy though, but for the centuries of parasitic usurping.

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