A Taker Nation: Dollar Addiction and Its Causes.

A Family’s budget is under stress. It had to take an income cut. The company for whom sole salaried person worked was not doing well in the market. What are its options? Increase income by moonlighting, or have other members of the family find work. Cut expenditure by trimming what is non-essential, or if there is not much flab to cut, then axe less of the essential spends. Don’t sacrifice the standard of living by dipping into the savings in the hope things would improve much before savings run out. Rely on the 2″ x 3″ plastic [credit card] and juggle credit between different ones till the game ends in a crash. What works for a family, works for a country too’ but there are too many important differences due to the complexities involved. Now that the US elections are out of the way, the talk of *fiscal cliff* is drawing attention. Unless Obama administration and Republicans agree on the way forward through fiscal compromise, the Tax Cuts instituted earlier would automatically end next year. Balancing a country’s budget, like in case of a family, needs either increase in income or decrease in expenditure, or both, until income at least matches expenditure. Government’s income is the taxes it levies. The more taxes it levies, the more is its income. Unluckily, unlike in family setting it is not a zero-sum game: taxpayers’ losses via taxes may not equal government income. If the economy is weak or faltering, then higher taxes can reduce or kill growth. If that means narrowing tax base, then higher taxes may not mean higher collections. Government spending on the other hand can cushion weaker sections of the society and also can stimulate demand by putting more money in the economy. Contrarily, if the spending cuts are imposed to trim deficit, then it may send signal to others to tighten belt in anticipation of a slow down. That may cause  reduced GDP growth or even a decline. Either way, trying to balance a national budget is a precarious exercise at best when the times are bad. When the times are good, who cares? Politicians are loathe to act as party poppers.
Many bright minds are exercised over what to do in such a situation. Global Economic Intersection [don’t be fooled by the name, it is at core USA centric] republished a post by Roger Mitchell, Reality Behind Austerity [The Arithmetic of Austerity. It is not a Fiscal Cliff, it is Death Spiral]. His basic thesis is that austerity is self perpetuating for a country running Trade Deficit. Let us see how.
  1. Under this “ideal,” balanced condition [balanced federal budget], a nation with a trade deficit (as the U.S. has), will send more dollars overseas than return to our economy. Under a balanced federal budget, the total dollars in the U.S. will decline by the amount of the trade deficit.
  2. Reduced GDP causes non-federal spending to decline, which causes lower tax collections. If nothing else changes, these reduced tax collections will increase the federal deficit, which will demand further austerity. To maintain a balanced budget, federal spending also would have to be reduced, but since federal spending is part of GDP, the reduction in federal spending would reduce GDP.[Mitchell has got this wrong. Government or Non Government spending is not a function of GDP expansion or contraction, though it influences both.  His Death Spiral should have read: Reduced Federal spending triggers decline in non-federal spending, together that reduces GDP, that in turn affects tax collection, and reduced tax collection means reduced federal spending. Reader can complete the loop in opposite direction too].
  3. Can we avoid the austerity death spiral simply by running a trade surplus? Yes, but the world’s balance of trade always is zero. So, if we run a trade surplus, other nation(s) must run a trade deficit. We would avoid depression by impoverishing other nations, which would cause them to have recessions and depressions.
His third point is that if USA were to manage trade surpluses by exporting much more than it imports, then in that case US GDP overall can still grow if the reduced or reducing domestic consumption were more than made up by trade surplus. But World Trade is indeed a zero-sum game. When other countries start running trade deficits as a result of USA’s trade surplus, then that would push them into recession he argues, but without explaining how. Many issues are at work here. For example, consumption levels in USA are way too high [5% of world population consuming some 25-30% of global resources] and are near saturation levels; so that Even US corporations are looking for growth elsewhere. But let us concentrate on the most vital issue.
What Mitchell advocates therefore is that USA must spend its way out of the crisis. Where would  Uncle Sam find the money to spend? Isn’t it simple? Just print it. ^^A Monetarily Sovereign government has the exclusively unlimited power to create its sovereign currency. Monetary Sovereignty is the foundation of economics.The United States is Monetarily Sovereign. It has the exclusively unlimited power to create the dollar^^.  In essence that is what Paul Krugman has argued too, and this is where family’s finances differ from a nation’s- a family can’t print its money. Somebody who can print money that is accepted by others as legal tender is a  Monetary Sovereign. In USA, it is Federal Reserve, who is the Monetary Sovereign; but it is owned privately unlike in China or Australia. But that is really a minor quibble. The real question is why has this particular Monetary Sovereign’s money printing defied economics or markets. Economic theory says price is a function of demand and supply [partial truth again, but let it pass]. If USA continues to print dollars endlessly to satisfy its insatiable hunger for goods, then its currency should go into a free fall due to over supply in world markets. Alternately or rather with it, hyper inflation should hit domestically [depreciating dollar would mean inflationary imports]. Neither of it has happened so far. The answer lies in the misinterpretation made by Mitchell in the first point above. Just because USA spends dollars to buy goods and services from others more than what others buy from her does not mean dollars move out of USA [It is true that some 60% or so of dollar bills or currency notes are held outside USA, but currency notes form a very small fraction of total book or electronic dollars, which can reside only in USA]. Purely in banking terms, the trade transactions result in a few dollar entries made for each in the books of some banks in the USA. Question is what do these entities, who hold dollar credits in banks in USA, do with those dollars? Well, let us take case of China. Chinese would have gladly exhausted their trillion dollar surpluses and more in buying into Warfare, Space, Aviation, oil, and other such vital industries. But USA won’t allow that out of self preservation instinct. Rest what USA has to offer is of a little interest to Chinese. So the dollar Chinese earn either sit in US Banks or are invested in US treasury bills or some such instruments. On such investments China of course earns some more dollars, which again stay in USA. Many of these dollars are also spent by China in buying strategic energy resources and raw materials in former Soviet Union territory, Australia, or the third world. So the dollar holdings [entries in bank books] get transferred from China to third nations, but dollars stay [on books of banks] in USA.
Then there is a compulsion to denote and settle trade transactions to which USA is not a party also in US dollars. The extent of this US dollar addiction of global trade is extraordinary. The following data from World Trade Organization gives some idea.
Despite a small declining trend, the domination of US dollar over foreign exchange transactions is complete. The next two tables give the trade share and currency share in trade, and percentage share of intra-regional trade in its total trade figures.
Here from *World payment currencies Versus Trade table* it may appear that Euro dominates. In absolute terms it may be true. But in relative terms, the story changes when one factors in the next *Intra-regional Merchandise Trade table*. Euro Zones total trade is placed at 27%, and out of this 71% or some 19% is internal. Therefore, out of 39% of the trade settled in Euro, only 20% [39-19] is accounted for by trade transaction outside Euro Zone. Even in this, Euro Zone’s trade with rest of the world would account for 8% [29% of 27%]. Thus only 12% [20-8] of trade, where no Euro Zone country is involved, is denominated and settled in Euro. What is the case of US dollars? USA’s total trade is placed at 12.5%, and out of this 48.7% or some 6% is internal to North America [NAFTA]. Therefore, out of 35% of the trade settled in US$, some 29% [35-6] is accounted for by trade transaction outside of North America. Even in this, USA’s trade with rest of the world would account for 6.4% [51.3% of 12.5%. Actually less, because 51.3% would include trade of Canada and Mexico with others] . Still some 23% [29-6] of world trade, where USA is not involved, is denominated and settled in US$. [for more on trade statistics visit here]
Pre-eminence of US$ in foreign exchange market, whose size now dwarfs every other economic activity, and in trade is not the complete story. Even in international debt markets, the dollar share of all outstanding debt instruments in 2009 was a high of 39%. Why does US$ gets this highly disproportionate importance? Earlier, this role was played by British Pound, when British Empire was in place. When British empire finally collapsed under the weight of two world wars, that mantle was assumed by the growing star of US empire. Despite rise of China, USA still remains the pre-eminent Super Power with unmatched fire power at its disposal. That is why it is seen as a last refuge in times of crisis. Even when financial crisis hit USA in 2007-2008, its currency didn’t weaken as it would have in case of any other country. A whiff of an impending danger, and global capital flees to the sanctuary of US dollars, protected as it will be by the military might of USA. Add to that unmatched advantage, the size of the US economy and the picture is somewhat complete but for a small bit. That small bit is covered by following charts.
What these two charts tell is a confirmation of immediately foregoing analysis. It is about the importance attached by central bankers of many countries to dollars in their management of economy, balance of payment, and exchange rate management. So much so that even sovereignty in national monetary and fiscal policies may be somewhat compromised. That is why trade is denominated in US dollars due to its stability compared to other currencies, concerned as exporters or importers would be with likely local currency realizations or payouts. It is this incurable addiction of rest of the world to US Dollars, which gives enormous power to Federal Reserve to keep its printing presses running. That addiction will be cured either the day Peddler collapses under his own weight or the Addict dies. 
This takes us back to the central thesis of Mitchell: A Monetary Sovereign can print currency at will. Even in this postulate he is mixed up. Sovereign is one who can force others to accept his currency as a *legal tender*. A force that is backed by lethal arsenal, and a readiness to use it, if necessary. But, what is meant by legal tender? A currency is a legal tender means it can be used to pay for goods or services, hire labour, buy resources, or settle debts. Seen correctly in this light, Currency or Money is a claim on resource or labour. The claim that has to be settled, violently if required. Money is a benign representation of debt backed by violence. Sovereign and Money are thus one and the same, who spring from and are surreal representation of debt backed by violence. Monetary Sovereign, therefore, is an oxymoron, like other economic myths. Abolish Sovereign or Money, and Debt would vanish. Cancel all Debt, and Sovereign or Money would vanish. 
Footnote: Paul Krugman locked horns with NIcholas Eberstadt of the American Enterprise Institute over latter’s remark that USA has become a nation of takers. That is of little concern to rest of the world except its desire to forge unity with those 99%. But for that those 99% as well as their brethren in rest of the world must see that USA has become a Taker Nation. 
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5 Responses to “A Taker Nation: Dollar Addiction and Its Causes.”

  1. Anonymous Says:

    I asked a dear friend in US for his opinion on your blog below. This is what he has responded with:In the old days – say under the gold standard – a nation's currency was tied to a gold asset base. I'm sure there was fudging, but the general idea was that you could issue only as much currency as you could back up.Also, it was thought that a government could borrow as much as it could pay back. Revenue to governments generally comes in the form of taxes. The Saudis have government owned oil so they have a different situation.If you collect $x in revenue and spend $x you have a balanced budget. Generally a good idea. All states and municipal governments (I think this is true and hopefully no exceptions) in the US are required to have a balanced budget. The federal government is not.JFK started borrowing big time. His view was "we owe it to ourselves, so who cares?" That was fine until the US started exporting its manufacturing base and China and other countries started accumulating surplus US dollars. The ready market for them was US treasury notes (2 years or less in maturity) and bonds (longer term). The incentive for creating more debt soared.GWB ran two wars off budget and started the Medicare Part D prescription drug benefit – about a trillion + dollars in deficit spending. So the US national debt which was about $5.8 trillion when Bush started is growing at $1 to $1.3 trillion per year and is now at $16 trillion +/-.When Clinton was President, the highest tax rate for earned income after deductions was 36%. He got Congress to enact a surcharge of 10% which made it 39.6%. To reach that level of taxation, a married couple filing a joint return would need $388,000 in adjusted gross income (taxable income determined by gross income minus deductions and allowances).Bush got those repealed and the highest rate became 35% – it was "temporary" to die in 2011. The next rates are 28%, 22% and 15%.Obama wants to let those Bush cuts die as they were originally slated to die when they were enacted under Bush. In 2011, Congress extended the tax cuts for one year with the proviso that if something were not done about spending, there would be automatic cuts starting on Dec 30, 2012. As I explained, the actual effect will be phased.At stake here is about $1 trillion over ten years in additional revenue – not a big deal at $100 billion annually in a $13-15 trillion economy. But it provides politicians with an excuse to yak as if they are actually doing something useful.The US has a seemingly unlimited capacity to issue debt. After all, it can raise $100 billion at the stroke of a pen.that's the long and short of it.

  2. Sadanand Patwardhan Says:

    Dear Anonymous,1. First some facts. Public debt is one part of the story. See the link [http://www.usdebtclock.org/]for real time view of public debt [16 trillion] and its components. But what is important and often missed out is Private debt. Together private and public debt is some $ 50 trillion or 3.25 times the GDP [http://rwer.wordpress.com/2011/12/30/chart-of-the-day-public-vs-private-us-debt-to-gdp-ratios/ and http://en.wikipedia.org/wiki/Financial_position_of_the_United_States#Debt%5D.2. Technically, any sovereign government can keep on issuing unlimited debt or create virtual [electronic] currency [no need any more to incur costs in printing notes and minting coins]. But in practice at the movement this privilege is enjoined only by USA. Why? If any other government dreamt of emulating USA, then its currency would go in a free fall because of abundant supply and little demand. Cost of imports will soar and hyper inflation would ensue. Or demand would collapse leading to depression. End would be same, no matter which route. Why doesn't it seem to happen with US$?3. The states and municipalities in USA have to balance their budgets or go bankrupt [which latter have already started doing so]. Why? Because they can't issue money, which is what federal reserve does. Their position is same as Greece, Ireland, Spain, Portugal, or Italy. These countries have ceded control over money issuance to ECB.4. How much more debt US can tolerate? There are more opinions out there than economists issuing them. US public debt is already more than GDP. In Greece it was 160% of GDP before crisis hit in the face. Since the economy is contracting, it has grown to 182.5% even after putting austerity measures in place. IMF and EU have now reached an agreement on the new target of 124% of GDP by 2020. Would it work? These are just figures in the air. How much debt can US economy tolerate? Would you trust an economist's figure?5. If creating more debt [that is creating money, please understand this], is the way out, then why talk about deficits and debt to GDP ratios. Just print [sorry, just push a button to credit e-dollars] money and be done with it. 6.Question is for how long US can live beyond its means by creating virtual dollars?Sadanand

  3. Anonymous Says:

    Part IDear Mr PatwardhanInterspersed in your email below (for the sake of easy reference) please find the response, point-wise from USA.1. This is true, but it was not part of the original discussion. Some figures put the total unfunded liabilities at well over $70 trillion. If you include unfunded pensions, etc. the number is even higher.The problem with all of these points is that all of the debt is not due immediately but over time and the real question is whether the debt obligations and the unfunded obligations can be met over time. View on this range from pessimistic to realistic to optimistic. Most projections over the long haul are a waste of time because we don't know how the economy will grow or shrink, whether there will be legislation to create de facto defaults that affect some or all beneficiaries, and to what extent the federal government can enhance revenues and assist state and local governments.2. Actually, in real terms the US dollar has declined substantially and inflation in the US is very high no matter what the public announcements say. The official inflation measures are based on outdated "baskets" of stuff that do not reflect reality.The reason that the US can continue to issue debt and by steps such as QE and so forth, "create" money supply is that it is not clear as stated in my response to point 1 above that the ability to meet the obligations is in jeopardy to the point of requiring compensating higher rates of return. In fact, rates have gone the other way.The other reason is that there is no place to park money without a different speculative risk – e.g. that presented by equities.US treasury securities are not only liquid, but also collateral for easy loans. So they are a sort of currency unto themselves.Europe, the UK, and to some extent China and Russia too are creating money supply – it is hidden against the massive numbers produced by the US.Ultimately, the US has assets well in excess of current debt and unfunded obligations. Of course, the US is not about to sell Alaska or Puerto Rico, but it can lease ANWR etc. A simple property tax or national sales tax can alter quite dramatically the US deficit and debt. Whether that is politically possible is another issue.3. What this misses is that they can and do issue debt. But here the ability to repay takes on a more critical role. Ultimately, the decision to file bankruptcy is both financial and political. The idea is to restructure debt and rewrite obligations rather than a liquidation because you cannot make a city disappear although perhaps a county could disappear and leave cities and towns to handle services, etc.

  4. Anonymous Says:

    Part – II4. Unanswerable question. The issue so far has been whether the US can pay interest obligations because as principal comes due, it is being rolled. Now that the Fed is buying debt, the problem is like a windmill.If the economy grows robustly, lots more is the answer. If we have another recession and a steep shortfall of revenue and rollover is stemmed, who knows?5. Creating more debt is not necessarily the equivalent of creating more money although it can have the same effect. Certainly, it creates the illusion that the US has the equivalent of additional tax revenue to meet obligations. The Fed is actually doing what is suggested. That explains why the dollar is not worth 5 euros or 5 GBP.Ultimately, international imbalances in prices, allowing for labor rates and true fungibility will come into line. Right now, the floating currency system is allowing imbalances to persist – a hamburger can cost $8 in Europe but $5 in the US. For true fungibility to take effect, we must have all countries and economies on relatively sound footing. Don't hold your breath.As long as even countries like Saudi Arabia are dependent on US markets for liquidity and solvency, and as long as Europe and Britain remain in slow growth to stagnation, and as long as China, India, and Russia remain in relative terms, a minor blip on the economic world stage — yes, I know they are growing and increasingly more important – the US dollar holds a lot of residual power.6.In about 20-50 years, the situation may change and the US find itself in dire straits but I think it is not smart to underestimate the power of the US economy which, even while struggling along, is holding up the world.

  5. Sadanand Patwardhan Says:

    1. Debts may be due in staggered fashion, but it shows how much debt has already built up. Take the case of *unfunded pension*. The pension obligations have to be met by working population [that can keep GDP growing rapidly]. Though USA's position is not as bad as Japan or Germany, the population is ageing. A narrower and narrower workforce will have to carry the burden of larger pensioners. Also further debt built up is continuing at an accelerated pace and is showing no signs of abating. Unless US economy expands very rapidly, a pipe dream?, debt burden would sink the ship. Now even the climate change has began to kick in affecting water availability even in places like USA, which experienced near drought situation in its grain belt.2. US treasuries are liquid because that is where even foreign funds also get parked. The main point of the post was to show it is the military might of USA, which is still holding dollar as world's reserve currency and of course its size [In the absence of former its relative weight in world economy would diminish]. Even if inflation data is fudged, which is what most governments do, the fact remains that dollar would not be no where near it is but for its military machine. If it were to depreciate substantially, as it would if not backed by coercive power, then inflation would get imported into a consuming nation dependent as it is on China and other countries. Taxes in any form take away purchasing power, which is what is hurting US economy right now. US undoubtedly has great advantage of natural assets and superb innovative culture, but the ability to exploit them could erode rapidly. 3. Question is not if states or municipalities can issue debt, they can and do, but if they cannot meet their obligations then they can't get away by printing dollars as federal reserve can. Cities can implode as basic services cannot be run in absence of money.4. Ability to roll over debt is embedded in ability to create fiat dollars, which at present seem to go on with impunity for the reasons discussed in the post.

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