Try Again. Fail again. Fail better – Disaster formula of US Federal Reserve

Bernanke-BubbleVivek Kaul
Now we know better. If we learn from experience, history need not repeat itself,” wrote economists George Akerlof and Paul Romer, in a research paper titled Looting: The Economic Underworld of Bankruptcy for Profit.
But that doesn’t seem to be the case with the Federal Reserve of United States, which seems to be making the same mistakes that led to the financial crisis in the first place. Take its decision to continue printing money, in order to revive the American economy.
In a press conference to explain the logic behind the decision, Ben Bernanke, the Chairman of the Federal Reserve of United States, said “
we should be very reluctant to raise rates if inflation remains persistently below target, and that’s one of the reasons that I think we can be very patient in raising the federal funds rate since we have not seen any inflation pressure.”
The Federal Reserve of United States prints $85 billion every month. It puts this money into the financial system by buying bonds. With all this money going around interest rates continue to remain low. And at low interest rates the hope is that people will borrow and spend more money.
As people spend more money, a greater amount of money will chase the same number of goods, and this will lead to inflation. Once a reasonable amount of inflation or expectations of inflation set in, people will start altering their spending plans. They will buy things sooner rather than later, given that with inflation things will become more expensive in the days to come. This will help businesses and thus revive economic growth.
The Federal Reserve has an inflation target of 2%. Inflation remains well below this level. As
Michael S. Derby writes in the Wall Street Journal As of the most recent reading in July, the Fed’s favoured inflation gauge, the personal consumption expenditures price index, was up 1.4% from a year ago.”
So, given that inflation is lower than the Fed target, interest rates need to continue to be low, and hence, money printing needs to continue. That is what Bernanke was basically saying.
Inflation targeting has been a favourite policy of central banks all over the world. This strategy essentially involves a central bank estimating and projecting an inflation target and then using interest rates and other monetary tools to steer the economy towards the projected inflation target. The trouble here is that inflation-targeting by the Federal Reserve and other central banks around the world had led to the real estate bubble a few years back. The current financial crisis is the end result of that bubble.
Stephen D King, Group Chief Economist of HSBC makes this point When the Money Runs Out. As he writes “the pursuit of inflation-targetting…may have contributed to the West’s financial downfall.”
King writes about the United Kingdom to make his point. “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessive loose…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
What this means is that the Bank of England(as well as other central banks like the Federal Reserve) kept interest rates too low for too long because inflation was at very low levels.
Low interest rates did not lead to inflation, with people borrowing and spending more, primarily because of low cost producers in China and other parts of the emerging world.
Niall Ferguson makes this point in
The Ascent of Money – A Financial History of the World in the context of the United States. As he writes Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labour kept down US wage costs. As a result, it was remarkably cheap to borrow money and remarkably profitable to run a corporation.”
The same stood true for the United Kingdom and large parts of the Western World. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards.
People who did not have the ability to repay were also being given loans. As King writes “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn’t need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.” What followed was a big bubble, which finally burst and its aftermath is still being felt more than five years later.
As newsletter write Gary Dorsch writes in a recent column “Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job.”
A lot of the money printed by the Federal Reserve over the last few years has landed up in all parts of the world, from the stock markets in the United States to the property market in Africa, and driven prices to very high levels. At low interest rates it has been easy for speculators to borrow and invest money, wherever they think they can make some returns.
Given this argument, it was believed that the Federal Reserve will go slow on money printing in the time to come and hence, allow interest rates to rise (This writer had also argued
something along similar lines). But, alas, that doesn’t seem to be the case.
As Claudio Borio and Philip Lowe wrote in 
the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run.”
Once these new round of bubbles start to burst, there will be more economic pain. The Irish author Samuel Beckett explained this tendency to not learn from one’s mistakes beautifully. As he wrote “Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”
The Federal Reserve seems to be working along those lines.
The article originally appeared on www.firstpost.com on September 20, 2013

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why Ben Bernanke must be now singing the Hotel California song

ben bernanke
Vivek Kaul
Ben ‘Shalom’ Bernanke is the Chairman of the Federal Reserve of United States, the American central bank. In the Monetary Policy Report to the Congress issued on March 1,2011, the Bernanke led Federal Reserve had assured the world at large that they had the tools needed to “remove policy accommodation at the appropriate time.”
In simple English what it meant was that as and when needed the Federal Reserve would stop printing money and at the same time be able to gradually withdraw all the money that they had printed and pumped into the financial system. This could be done without much hassle.
In the aftermath of the financial crisis starting in mid September 2008, the Federal Reserve of United States had started to print dollars and pump them into the financial system. This was done to ensure that there was enough money going around and thus interest rates continued to remain low. At low interest rates the hope was that the American consumer would start borrowing and spending money again. And this spending would help revive the American economy, which had slowed down considerably in the aftermath of the financial crisis.
This process of printing money in the hope of reviving economic growth came to be referred as “quantitative easing”. The risk with quantitative easing as is the case with all money printing was that too much money would chase the same number of goods and services, and push up their prices considerably. Hence, there was a risk of high inflation. Given this, at an appropriate time the Federal Reserve would have to stop money printing and gradually pump out all the money they had printed and pumped into the financial system.
Speaking to the media on June 19, 2013, Bernanke said
If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.
Bernanke further said that “in this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7%, with solid economic growth supporting further job gains.”
What he meant by this was that if the American economy keeps improving and growing, the Federal Reserve would reduce money printing gradually later this year and would totally wind it down by the middle of next year. The Federal Reserve prints $85 billion every month to buy both private and government bonds. It pays for the bonds it buys by printing dollars. This is how it pumps printed money into the financial system and ensures that interest rates continue to remain low.
The idea of the Fed first going slow on money printing and then stopping it totally, has sent markets (stock,bond and commodity) around the world into a tizzy. When the Federal Reserve started printing money to keep interest rates down, the hope was that it would manage to get the American consumer borrowing and spending again.
But that did not happen at the same pace as the Federal Reserve hoped it would, given that the American consumer was just coming out of one round of a huge borrowing binge and wasn’t in the mood to start borrowing all over again. Meanwhile the financial system was flush with money available at close to 0% interest rates. This led to big financial investors (the investment banks and the hedge funds of the world) spotting an opportunity.
They could borrow money at very low interest rates and invest it all across the world, and make huge returns. This trade, where money was borrowed in American dollars and invested in financial assets all across the world, came to be referred as the dollar carry trade.
The difference between the return the investors make on their investment and the interest that they pay for borrowing money in dollars is referred to as the ‘carry’ they make.
The dollar carry trade would work only as long as the interest rates in the United States continued to remain low. Bernanke’s recent statement made it very clear that chances were that the Federal Reserve would gradually wind down on money printing. This meant that the financial system would no longer be flush with money as it had been, in turn leading to higher interest rates. Or as Bernanke put it “if interest rates go up for the right reasons – that is, both optimism about the economy and an accurate assessment of monetary policy – that’s a good thing. That’s not a bad thing.”
This is as clear as a central banker can get and has led to a bloodbath in markets all over the world. The Dow Jones Industrial Average, America’s premier stock market index fell by 353.87 points to close at 14,758.32 points yesterday. The BSE Sensex fell by 526 points to close at 18,719.29 points yesterday.
Stock markets in other parts of the world fell as well. This was primarily on account of the unravelling of the dollar carry trade. With American interest rates expected to go up, investors were busy withdrawing their money from various markets and repatriating it back to the United States.
The wave of selling in the Indian bond market was so huge that the market had to be briefly shut down yesterday when there were only sellers and no buyers in the market. This also had a huge impact on the rupee dollar rate. When foreign investors sell out of Indian financial assets they get paid in rupees. When they repatriate this money back into the United States the rupees need to be converted into dollars. So the rupees are sold to buy dollars from the foreign exchange market.
When this happens there is a surfeit of rupees in the market and a huge demand for dollars. This has led to the rupee rapidly losing value against the dollar. Around one month back one dollar was worth Rs 55. Yesterday one dollar was worth close to Rs 60. It touched Rs 59.98 during the intra day trading.
In fact the big financial investors are even selling out on American government bonds. The return on 10 year American treasuries rose to 2.42% yesterday as investors sold out of these bonds. The 10 year American treasury is a bond issued by the American government to finance its fiscal deficit or the difference between what it earns and what it spends. In the beginning of May, the return on the 10 year American treasuries was at 1.63%.
It is important to understand here that interest rates and bond prices are inversely correlated i.e. an increase in interest rates leads to lower bond prices. And given that interest rates are expected to rise, the bond prices (including that of the 10 year American treasury) will fall. Hence, investors wanting to protect themselves against losses are selling out of these bonds. When investors sell out on bonds there prices fall. At the same time the interest that is paid on these bonds by the government continues to remain the same, thus pushing up overall returns for anybody who buys these bonds.
This explains why the return on the 10 year American treasury bond has been going up. The trouble is that the return on the 10 year American treasury acts as a benchmark for interest rates on all kinds of loans from home loans to dollar carry trade loans. So if the return on the 10 year American treasury is going up, then the interest rates on all kinds of loans goes up as well. This is because the government is deemed to be safest lender and hence returns on all kinds of other loans need to be higher than the return made on lending to the government.
Rising interest rates could very well put the American economic recovery in a jeopardy, which wouldn’t have been the idea behind what Bernanke said two days earlier.
What this tells us is that investors and markets all around the world haven’t really liked Federal Reserve’s decision to wind down money printing in the months to come and are voting against it. Also, Bernanke had clearly said that the Federal Reserve had no plans of withdrawing all the money it had printed and pumped into the financial system. It was only planning to go a little slow on the money printing. Or as Bernanke put it
akin to letting up a bit on the gas pedal.”
“Putting on the monetary brakes would entail selling bonds out of the Fed’s portfolio, and that’s not happening any time soon,” Bernanke said.
As has been pointed out earlier, the Federal Reserve had been buying bonds to pump the money that it is printing into the financial system. When it wants to withdraw this money it will have to start selling back all the bonds that it has bought. But there are clearly no such plans.
So even the idea of the Federal Reserve slowing down money printing is not acceptable to the market and the big financial investors, who have got so used to the idea of ‘easy money’ and all the benefits that it has brought to them.
Imagine what would happen once the Federal Reserve wants to start sucking out all the money that it has printed and pumped into the market. Just the idea of going slow on money printing has led to a market mayhem all over the world. Ben Bernanke and the Federal Reserve are now finding out that removing the so-called policy accommodation is going to be nowhere as easy as they thought it would be more than two years back.
Or as the last few lines of
Hotel California sung by The Eagles go “We are programmed to receive. You can check-out any time you like, But you can never leave.” Chances are Ben ‘Shalom’ Bernanke must be humming that number right now.
The article originally appeared on www.firstpost.com on June 21, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

Before Bernanke’s statement: Why foreign investors are selling out on bonds

3D chrome Dollar symbol
Vivek Kaul
The foreign institutional investors have sold out $4.6 billion worth of bonds from the Indian debt market over the last one month. This is primarily because of the unwinding of the dollar carry trade.
In the aftermath of the financial crisis that started in September 2008, the Federal Reserve of United States, the American central bank, started printing truckloads of money. This money was flushed into the financial system. The idea being with enough money going around, the interest rates would remain low. At low interest rates American citizens were more likely to borrow and spend. And this spending would create economic growth, which had fallen dramatically in the aftermath of the crisis.
The trouble of course was that Americans were just coming out from a horrible round of borrowing binge which had gone all wrong. And given that they were in no mood to borrow more. They first wanted to pay off their existing loans. So the financial system was flush with money available at low interest rates but the American citizens did not want to borrow.
This led to banks and other financial institutions borrowing at very low interest rates and investing that money in different financial markets across the world. This trade came to be known as the dollar carry trade. Money was raised in dollars at low interest rates and invested in stock, bond and commodity markets all over the world.
The difference between the return the investors make on their investment and the interest that they pay for borrowing money in dollars is referred to as the ‘carry’ they make.
This trade has been a boon to big financial firms which were reeling in the aftermath of the financial crisis and has helped them back on their feet. But like all things which seem ‘good’, this might be coming to an end as well.
Later today the Federal Open Market Committee(FOMC) of the Federal Reserve will issue a statement in which it is likely to hint that it will cut down on further money printing. Ben Bernanke, the Chairman of the Federal Reserve, 
hinted about it in a testimony to the Joint Economic Committee of the American Congress on May 23, 2013.
As he said “if we see continued improvement and we have confidence that that is going to be sustained, then we could in — in the next few meetings — we could take a step down in our pace of purchases.”
The Federal Reserve pumps money into the American financial system by printing money and using it to buy bonds. This ensures that there is no shortage of money in the system, which in turn ensures low interest rates.
What Bernanke said was that if the Federal Reserve feels that the economic scenario is improving, it would taper down the bond purchases. This basically meant that the Federal Reserve would go slow on money printing.
If and when that happened, the interest rates would start to go up as the financial system would no lunger be slush with money. In fact the interest rates have already started to go up. The return on the 10 year US treasury bond has gone up. On May 2, 2013, the return was at 1.63%. As on June 18, 2013, the return had shot up to 2.19%. A US treasury bond is a bond issued by the American government to finance its fiscal deficit. The fiscal deficit is the difference between what a government earns and what it spends.
The return on 10 year US treasury acts as a benchmark for the interest rates on other loans. If the return on 10 year US treasury goes up, what it means is that interest charged on other loans will also go up in the days to come.
This means that those financial institutions which have borrowed money for the dollar carry trade will be paying a higher interest. A higher interest would mean a lower return on investment on their trade i.e. a lower carry.
This is the reason why these investors are unwinding their dollar carry trade. In an Indian context this has meant that they have been selling out on the bonds they had invested in. As mentioned earlier over the last one month the foreign investors have sold bonds worth $4.6 billion.
When the foreign investors sell these bonds they get paid in rupees. This money needs to be repatriated to the United States and hence needs to be converted into dollars. So the rupees are sold to buy dollars from the foreign exchange market.
When this happens there is a surfeit of rupees in the market and a huge demand for dollars. This has led to the rupee rapidly losing value against the dollar. Around one month back one dollar was worth Rs 55. Now its worth close to Rs 59 (around Rs 58.75 as I write).
The question that arises here is how are the foreign investors reacting in the stock market? They have much more invested in the stock market than they had in the bond market.
Over the last one month the foreign institutional investors have bought stocks worth Rs 382.88 crore, which is a low number, though in the positive territory. In the month of May 2013, the foreign investors had bought stocks worth Rs 14,465.90 crore. Since the beginning of this year they have bought stocks worth Rs 57,644.33 crore.
So that tells us very clearly that foreign institutional investors are going slow even on their stock purchases. But they haven’t sold out on stocks totally, as they have in case of bonds. The answer lies in the fact that returns in the bond market are limited. The return on the 10 year India government bond was at 7.28% as on June 18,2013. The borrowing costs for the foreign investors have gone up. A depreciating rupee also limits their overall return. So it makes sense for them to get out of bonds.
In case of the stock market there is no limit to the overall return that can be made. And that explains to some extent why the bond market has borne the brunt of the unwinding of the dollar carry trade. How things pan out from here depends on what the Bernanke led FOMC says later tonight.
The article originally appeared on www.firstpost.com on June 19,2013.

(Vivek Kaul is a writer. He tweets @kaul_vivek)
 
 

The only stock tip you will ever need: Watch the Dow

Vivek Kaul
The Dow Jones Industrial Average (DJIA), America’s premier stock market index, has been quoting at all-time-high levels. On 7 March 2013, it closed at 14,329.49 points. This has happened in an environment where the American economy and corporate profitability has been down in the dumps.
The Indian stock markets too are less than 10 percent away from their all-time peaks even though the economy will barely grow at 5 percent this year.
All the easy money created by the Federal Reserve is landing up in the stock market. So the stock market is going up because there is too much money chasing stocks. ReutersIn this scenario, should one  dump stocks or buy them?
The short answer is simple: as long as the other markets are doing fine, we will do fine too. The Indian market’s performance is more closely linked to the fortunes of other stock markets than to Indian economic performance.
So watch the world and then invest in the Sensex or Nifty. You can’t normally go wrong on this.
Let’s see how the connection between the real economy and the stock market has broken down after the Lehman crisis.
The accompanying chart below proves a part of the point I am trying to make. It tells us that the total liabilities of the American government are huge and currently stand at 541 percent of GDP. The American GDP is around $15 trillion. Hence the total liability of the American government comes to around $81 trillion (541 percent of $15 trillion).
Source: Global Strategy Weekly, Cross Asset Research, Societe Generate, March 7, 2013
Source: Global Strategy Weekly, Cross Asset Research, Societe Generate, March 7, 2013
The total liability of any government includes not only the debt that it currently owes to others but also amounts that it will have to pay out in the days to come and is currently not budgeting for.
Allow me to explain.  As economist Laurence Kotlikoff wrote in a column in July last year, “The 78 million-strong baby boom generation is starting to retire in droves. On average, each retiring boomer can expect to receive roughly $35,000, adjusted for inflation, in Social Security, Medicare, and Medicaid benefits. Multiply $35,000 by 78 million pairs of outstretched hands and you get close to $3 trillion per year in costs.”
The $3trillion per year that the American government needs to pay its citizens in the years to come will not come out of thin air. In order to pay out that money, the government needs to start investing that money now. And that is not happening. Hence, this potential liability in the years to come is said to be unfunded. But it’s a liability nonetheless. It is an amount that the American government will owe to its citizens. Hence, it needs to be included while calculating the overall liability of the American government.
So the total liabilities of the American government come to around $81 trillion. The annual world GDP is around $60 trillion. This should give you, dear reader, some sense of the enormity of the number that we are talking about.
And that’s just one part of the American economic story. In the three months ending December 2012, the American GDP shrank by 0.1 percent. The “U3” measure of unemployment in January 2013 stood at 7.9 percent of the labour force. There are various ways in which the Bureau of Labour Standards in the United States measures unemployment. This ranges from U1 to U6. The official rate of unemployment is the U3, which is the proportion of the civilian labour force that is unemployed but actively seeking employment.
U6 is the broadest definition of unemployment and includes workers who want to work full-time but are working part-time because there are no full-time jobs available. It also includes “discouraged workers”, or people who have stopped looking for work because economic conditions make them believe that no work is available for them. This number for January, 2013, stood at 14.4  percent.
The business conditions are also deteriorating. As Michael Lombardi of Profit Confidential recently wrote, “As for business conditions, they appear bright only if you look at the stock market. In reality, they are deteriorating in the US economy. For the first quarter of 2013, the expectations of corporate earnings of companies in the S&P 500 have turned negative. Corporate earnings were negative in the third quarter of 2012, too.”
The average American consumer is not doing well either. “Consumer spending, hands down the biggest contributor of economic growth in the US economy, looks to be tumbling. In January, the disposable income of households in the US economy, after taking into consideration inflation and taxes, dropped four percent—the biggest single-month drop in 20 years!,” writes Lombardi.
Consumption makes up for nearly 70 percent of the American GDP. And when the American consumer is in the mess that he is where is the question of economic growth returning?
So why is the stock market rallying then? A stock market ultimately needs to reflect the prevailing business and economic conditions, which is clearly not the case currently.
The answer lies in all the money that is being printed by the Federal Reserve of the United States, the American central bank. Currently, the Federal Reserve prints $85 billion every month, in a bid to keep long-term interest rates on hold and get the American consumer to borrow again. The size of its balance-sheet has touched nearly $3 trillion. It was at around $800 billion at the start of the financial crisis in September 2008.
As Lombardi puts it, “When trillions of dollars in paper money are created out of thin air and interest rates are simultaneously reduced to zero, where else would investors put their money?”
All the easy money created by the Federal Reserve is landing up in the stock market.
So the stock market is going up because there is too much money chasing stocks. The broader point is that the stock markets have little to do with the overall state of economy and business.
This is something that Aswath Damodaran, valuation guru, and professor at the Columbia University in New York, seemed to agree with, when I asked him in a recent interview about how strong is the link between economic growth and stock markets? “It is getting weaker and weaker every year,” he had replied.
This holds even in the context of the stock market in India. The economy which was growing at more than 8 percent per year is now barely growing at 5 percent per year. Inflation is high at 10 percent. Borrowing rates are higher than that. When it comes to fiscal deficit we are placed 148 out of the 150 emerging markets in the world. This means only two countries have a higher fiscal deficit as a percentage of their GDP, in comparison to India. Our inflation rank is around 118-119 out of the 150 emerging markets.
More and more Indian corporates are investing abroad rather than in India (Source: This discussion featuring Morgan Stanley’s Ruchir Sharma and the Chief Economic Advisor to the government Raghuram Rajan on NDTV)But despite all these negatives, the BSE Sensex, India’s premier stock market index, is only a few percentage points away from its all-time high level.
Sharma, Managing Director and head of the Emerging Markets Equity team at Morgan Stanley Investment Management, had a very interesting point to make. He used thefollowing slide to show how closely the Indian stock market was related to the other emerging markets of the world.
d
India’s premier stock market index, is only a few percentage points away from its all-time high level.
As he put it, “It has a correlation of more than 0.9. It is the most highly correlated stock market in the entire world with the emerging market averages.”
So we might like to think that we are different but we are not. “We love to make local noises about how will the market react pre-budget/post-budget and so on, but the big picture is this. What drives a stock market in the short term, medium term and long term is how the other stock markets are doing,” said Sharma. So if the other stock markets are going up, so does the stock market in India and vice versa.
In fact, one can even broaden the argument here. The state of the American stock market also has a huge impact on how the other stock markets around the world perform. So as long as the Federal Reserve keeps printing money, the Dow will keep doing well. And this in turn will have a positive impact on other markets around the world.
To conclude let me quote Lombardi of Profit Confidential again “I believe the longer the Federal Reserve continues with its quantitative easing and easy monetary policy, the bigger the eventual problem is going to be. Consider this: what happens to the Dow Jones Industrial Average when the Fed stops printing paper money, stops purchasing US bonds, and starts to raise interest rates? The opposite of a rising stock market is what happens.”
But the moral is this: when the world booms, India too booms. Keep your fingers crossed if the boom is lowered some time in the future.
The article originally appeared on www.firstpost.com on March 8, 2013.
Vivek Kaul is a writer. He tweets @kaul_vivek

Why the dollar continues to look as good as gold

3D chrome Dollar symbol
Vivek Kaul 
 
Over the last few years a mini industry predicting the demise of the dollar has evolved. This writer has often been a part of it. But nothing of that sort has happened.
There are fundamental reasons that have led this writer and other writers to believe that dollar is likely to get into trouble sooner rather than later. The main reason is the rapid rate at which the Federal Reserve of United States has printed dollars over the last few years. This rapid money printing is expected to create high inflation sometime in the future.
But whenever markets have sensed any kind of trouble in the last few years money has rapidly moved into the dollar. In fact, even when the rating agency Standard & Poor’s downgraded America’s AAA status, money moved into the dollar. It couldn’t have been more ironical.
What is interesting nonetheless that the doubts on the continued existence of the dollar are getting graver by the day. Gillian Tett, the markets and finance commentator of 
The Financial Times has a very interesting example on this in her latest column Is Dollar As Good as Gold published on March 1, 2013.
As Tett writes “Should we all worry about the outlook for the mighty American dollar? That is a question that many economists and market traders have pondered as economic pressures have grown. But in recent weeks Virginia’s politicians have been discussing it with renewed zeal. Last month Bob Marshall, a local Republican, submitted a bill to the local assembly calling on the state to study whether it should create its own “metallic-based” currency.”
The reason for this as the bill pointed out was that “Unprecedented monetary policy actions taken by the Federal Reserve … have raised concern over the risk of dollar debasement.”
In fact Virginia is not the only state in the United States that has been talking about a currency backed by a precious metal(read gold). As Tett puts it “So guffaw at the Virginia bill if you like. And if you want an additional chuckle, you might also note that a dozen other state assemblies, in places such as North and South Carolina, have discussed similar ideas; indeed, Utah has a gold and silver depository which is trying to back debit cards with gold.”
The point is that the debate on the demise of the dollar if it continues to be printed at such a rapid rate, is now moving into the mainstream.
So what will be the fate of the US dollar? Will it continue to be at the heart of the global financial system? These are questions which are not easy to answer at all. There are too many interplaying factors involved.
While there are fundamental reasons behind the doubts people have over the future of the dollar. There are equally fundamental reasons behind why the dollar is likely to continue to survive. But one good place to start looking for a change is the composition of the total foreign exchange reserves held by countries all over the world. The International Monetary Fund puts out this data. The problem here is that a lot of countries declare only their total foreign exchange reserves without going into the composition of those reserves. Hence the fund divides the foreign exchange data into allocated reserves and total reserves. Allocated reserves are reserves for countries which give the composition of their foreign exchange reserves and tell us exactly the various currencies they hold as a part of their foreign exchange reserves.
Dollars formed 71% of the total allocable foreign exchange reserves in 1999, when the euro had just started functioning as a currency. Since then the proportion of foreign exchange reserves that countries hold in dollars has continued to fall. In fact in the third quarter of 2008 (around the time Lehman Brothers went bust) dollars formed around 64.5% of total allocable foreign exchange reserves. This kept falling and by the first quarter of 2010 it was at 61.8%. It has started rising since then and as per the last available data as of the third quarter of 2012, dollars as a proportion of total allocable foreign exchange reserves are at 62.1%. The fall of the dollar has all along been matched by the rise of the euro. But with Europe being in the doldrums lately it is unlikely that countries will increase their allocation to the euro in the days to come. Between first quarter of 2010 and the third quarter of 2012, the holdings of euro have fallen from 27.3% to 24.14%.
So the proportion of dollar in the total allocable foreign exchange reserves has fallen from 71% to 62.1% between 1999 and 2012. But then dollar as a percentage of total allocable foreign exchange reserves in 2012 was higher than it was in 1995, when the proportion was 59%.
So when it comes to international reserves, the American dollar still remains the currency of choice, despite the continued doubts raised about it. One reason for it is the fact that there has been no real alternative for the dollar. Euro was seen as an alternative but with large parts of Europe being in bigger trouble than America, that is no longer the case. Japan has been in a recession for more than two decades not making exactly yen the best currency to hold reserves in.
The British Pound has been in doldrums since the end of the Second World War. And the Chinese renminbi still remains a closed currency given that its value is not allowed to freely fluctuate against the dollar.
So that leaves really no alternative for countries to hold their reserves in other than the American dollar. But that is not just the only reason for countries to hold onto their reserves in dollars. The other major reason why countries cannot do away with the dollar given that a large proportion of international transactions still happen in dollar terms. And this includes oil.
The fact that oil is still bought and sold in American dollars is a major reason why American dollar remains where it is, despite all attempts being made by the American government and the Federal Reserve of United States, the American central bank, to destroy it. And for this the United States of America needs to be thankful to Franklin D Roosevelt, who was the President from 1933 till his death in 1945 (in those days an individual could be the President of United States for more than two terms).
At the end of the Second World War Roosevelt realised that a regular supply of oil was very important for the well being of America and the evolving American way of life. He travelled quietly to USS 
Quincy, a ship anchored in the Red Sea. Here he was met by King Ibn Sa’ud of Saudi Arabia, a country, which was by then home to the biggest oil reserves in the world.
The United States’ obsession with the automobile had led to a swift decline in domestic reserves, even though America was the biggest producer of oil in the world at that point of time. The country needed to secure another source of assured supply of oil. So in return for access to oil reserves of Saudi Arabia, King Ibn Sa’ud was promised full American military support to the ruling clan of Sa’ud.

Saudi Arabia over the years has emerged as the biggest producer of oil in the world. It also supposedly has the biggest oil reserves. It is also the biggest producer of oil within the Organisation of Petroleum Exporting Countries (OPEC), the oil cartel. Hence this has ensured that OPEC typically does what Saudi Arabia wants it to do. Within OPEC, Saudi Arabia has had the almost unquestioned support of what are known as the sheikhdom states of Bahrain, Kuwait, United Arab Emirates and Qatar.
In fact, in the late 1970s efforts were made by other OPEC countries, primarily Iran, to get OPEC to start pricing oil in a basket of currencies (which included the dollar) but that never happened as Saudi Arabia put its foot down on any such move. This led to oil being continued to be priced in dollars and was a major reason for the dollar continuing to be the major international reserve currency.
It is important to remember that the American security guarantee made by President Roosevelt after the Second World War was extended not to the people of Saudia Arabia nor to the government of Saudi Arabia but to the ruling clan of Al Sa’uds. Hence, it is in the interest of the Al Sa’ uds to ensure that oil is continued to be priced in American dollars.
And until oil is priced in dollars, any theory on the dollar being under threat will have to be taken with a pinch of salt because the world will need American dollars to buy oil. Also it is important to remember that financially America might be in a mess, but by and large it still remains the only superpower in the world. In 2010, the United States spent $698billion on defence. This was 43% of the global total.
So dollar in a way will continue to be as good as gold. Until it snaps.

The piece originally appeared on www.firstpost.com on March 5, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek and continues to actively bet against the dollar by buying gold through the mutual fund route)