US Treasury supports dollars

Reading time: 7 – 12 minutes

Despite remarks of Chinese officials and offhand comments of the US Treasury Secretary, the Fed flow of funds accounts for Q4 2008 indicate that the US Monetary Authority acted, in fact, like a world central banker, supporting the dollar as the primary international reserve currency.

First, public funds used to support AIG were allowed to pass through to foreign banks and investors, boosting dollars available abroad, that flowed back into interbank assets in the US.

US Treasury Department

Second, the Fed and the Treasury issued over $500 billion in currency swaps with foreign central banks, pushing an extra dose of dollars into international markets that also ended up in US interbank assets. These actions were taken despite the impact on the exchange rate and domestic public opinion.

Since the US monetary authorities are the only source of dollars and since the dollar is the de facto world reserve currency, setting aside criticism of the ad hoc aspect of US government actions during Q4 2008, these actions were not inconsistent with a concern for financial stability beyond US borders.

However, since the Obama administration has come to power, the US Congress has enacted massive “stimulus” measures that bode ill for the eventual value of the dollar and long-term inflation.

Although the effects will not be felt for some time, Congress may have already set in motion government spending on a scale that will make it impossible for the dollar to continue as the premier world reserve currency.

US trade deficit grows

Below are selected figures from the Fed flow of funds table F.107 (Rest of the World), comparing annually and seasonally adjusted flows for Q4 2007 with Q4 2008.

Here we see the substantial impact of  government intervention in the international dollar market.

In Q4 2008, the US trade deficit was no longer the primary source of dollar funds to the rest of the world, surpassed by direct government intervention in the market.

The foreign currency swaps boosted interbank dollar assets in the hands of non-residents, at a time when foreign institutions were pulling out of dollar repos and agency securities on a grand scale.

The combination of the trade deficit and currency swaps, provided funds for non-residents to reduce dollar claims of creditors, while increasing direct foreign investment in the US and in US Treasuries.

Note: Some figures are significantly larger than actual flows, because of adjustment to an annual basis.

F.107 Principal US net flows with the Rest of the World

Real estate and direct investment

Although foreign central bankers may grumble about what inflation may do to their dollar monetary assets, there is only one way they can, as a group, stop holding dollars — use dollars in the US to buy non-financial assets from US residents.

The flow of funds accounts put foreign holdings of dollar financial assets at $16.9 trillion as of Q4 2008 — up $6.4 trillion since 2004 and growing.

With the threat of inflation, that’s a lot of money that could move into US hard assets.

Other countries are hooked on dollars because the US  — at least until recently — has favored free trade and has few barriers to foreign exporters who are eager to keep their factories humming and local employment high.

So, if foreign holders of dollar financial assets are spooked by portents of inflation, what would be the logical step for them to take?

Certainly, it would not be to buy US debt, but instead hard assets, probably in the form of direct investments and real estate.

If the Bank of China were to dump dollar holdings in the world market, other foreign holders will be on the other side of the trade and the foreign holdings of dollar financial assets would not change — while sellers of these assets would take a loss.

Foreigners will shun dollar assets

By gradually using dollar financial assets to buy hard assets from US residents, the rest of he world could reduce exposure to dollar risk.

US income-producing, commercial real estate is cheap (because of the recession) while foreigners have the cash and motivation (fear of inflation) to pick up these assets.

Foreigners also have the cash to clean up REIT finances.

The REIT market is already securitized, providing management, local know-how, and easy acquisition.

The increase in direct foreign investment in the US during Q4 2008, despite hard times, suggests that movement away from debt into hard assets is already underway.

Inflation threatens dollar bonds

Obviously, inflation is not friendly to bond investors, nor to the dollar’s position as the world reserve currency.

In recent years, the major support for the US bond market (except for municipal bonds) has come from foreign holders of dollar assets.

A high level of dollar inflation poses a threat to the US bond market and dollar supremacy, especially since foreign investors, with sufficient monetary motivation, will shift attention from bonds to US hard assets that offer protection against a devaluating currency.

Inflation will also impact US insurance companies, traditional buyers of debt securities, further constricting supply.

Inflation-protected Treasuries?

Unless the US Treasury comes up with a bond that offers real protection against inflation (like the Brazilian ORTN of the 1960s), the monetary authorities will not be able to soak up money that is being spent by a profligate Congress.

Inflation will get worse, pushing even more money into “hard assets”.

Even so, if the rest of the world, fearing US inflation, moves from dollar financial assets into real estate and direct US investment, their will no longer be the huge captive market for Treasury bonds, represented by the accumulated traded deficits over many years.

Unless extremely aggressive bank reserve policy is adopted, the government may have no alternative but to print money;

Inflation will go wild, and the dollar will be finished as a world reserve currency.

However, soaring prices of US income-producting, real estate may, in certain circumstances, prove to be an acceptable backing for an international currency — a new “gold”, so to speak. But, this will not save the dollar.

It’s now  up to US voters

It would be better, therefore, for the American public to wake up in time from the Obama pink dream and kick the Democrats out of Congress, saving the dollar from seemingly inevitable debasement.

If Obama follows the wishes of his friends in the labor unions, enacting protectionist legislation, the country and the dollar will be in for very bad times indeed.

There is an inherent conflict between what is necessary to keep the dollar as the world reserve currency and what is necessary to keep local politicians in office.

The United States has reaped huge benefits by having the dollar as the world reserve currency for over twenty years.

Wall Street’s abandonment of conservative financial principals has combined with Congress’s populist politics, creating a situation that threatens to end the reign of the dollar.

It is ironic the Paul Volcker has played a role in administrations that both strengthened and weakened the dollar.