Thursday, January 27, 2011

Questions about the Dollar and Debt

A reader asked after reading "Paul Ryan and Bankruptcy":

1) What would happen to the dollar if other countries stopped using it as "the global reserve currency"? and...

2) What would happen if China decided to stop buying our debt (treasury securities)?

Okay, so I am studying to be an economist with (eventually and hopefully) an expertise in Catholic Social Teaching. I am at a school that specializes in Heterodox (outside of the mainstream) economics and most especially its money theory.

Their theory of money, however, isn't as much a theory as much as it is a description of the way that money functions. Don't just take my word for it, read for yourself.

It springs from the Chartalism of Knapp, Innes, Lerner, Minsky, and more recently Wray, Kelton, and Mosler. It has become known as Modern Money Theory even though it’s not a theory at all. It is also more appropriately called Functional Finance.

It is not without criticisms, but I urge you to tackle the issue for yourself to see what you think and remember to not just think according to tradition. Don't get caught in the trap of continuing on old adages from the gold standard or comparing our monetary system to Europe because they are not the same. This "theory" only applies to nations who are sovereign in their own currency. That is they control the power to create it, destroy it, and demand it in taxes. Part of the disconnect with the mainstream is because they fall into these traps.

So to answer the questions as best I can:

1) If all the nations dropped the dollar as their reserve currency in favor of another, say the Chinese "Yuan," what would happen? As of right now, some countries use the US dollar as their official currency, some peg their currency to the dollar, and the rest float or peg to another currency. Those that peg to ours or use ours have no control over their currency. They rely on their ability to obtain US dollars by selling us their goods or exchanging another currency in an international exchange market. Other countries hold dollars in order to buy American goods, have them in reserve to exchange for other currencies, or may decide to hold dollars as a store of wealth in times of uncertainty. Note that holding dollars means having an account at the Federal Reserve Bank of the United States. All of their dollars are "stored" in a computer balance sheet at the bank. They don't actually hold the paper currency.

If these countries, for whatever reason but let’s say because of our deficits, decide to abandon the dollar they would flood the international market with the dollar. They would try to exchange it for their own currencies or another currency, say the Yuan, which would cause the price of the dollar to drop relative to other currencies. What does that mean? All else equal, US goods are now cheaper relative to other nations' goods than they were. The large trade imbalance would move back toward equilibrium and may even cause an export boom. That is, imports would drop and exports would rise. This also means inflation of the dollar domestically. Our savings and our debt would decrease in value, all else equal.

Is it really a concern? I would say not in the foreseeable future and here's why: The U.S. is a major buyer of these countries' goods, especially China. If they dumped our dollars, they would hurt their own economies where it mattered most: their exporting sectors. Most nations WANT dollars because that means they are selling goods to the US which means more income and jobs at home. China especially. The world is largely tied to the success of the United States economy. Developing nations bounced back much more quickly from the most recent recession because they didn't put themselves in the same financial mess that we did.

2) I think a question to ask first is, why do we sell securities in the first place?

The United States never has nor doesn't have any dollars. It is all a matter of book keeping at the Federal Reserve Bank. When it spends, its own balance sheet is deducted from and a business's is added onto. They change the numbers on a computer. They same goes for paying with cash or check, they just change numbers at the Federal Reserve Bank, we all have an account there. When the government taxes us it takes away our money from the account. Taxes deduct our spending power, government spending adds to it. So deficits are a matter of adding spending power to our economy.

So what about treasury securities, or bonds? A U.S. Treasury security is a savings account at the Federal Reserve bank. Dollars from your checking account are deducted and added to the government's account. At a later date, the government sends back the money plus interest. So, essentially, buying securities is transferring money from checking accounts to savings accounts.

So the foreign nations who buy our debt are simply taking the dollars they make selling us goods and buy securities with them transferring their dollar holdings from checking to saving in order to earn interest.

Remember, the US doesn't tax to raise revenue because it doesn't have or not have any money. Taxes simply take away our purchasing power. They regulate the value of the dollar and the purchasing power of the individuals in our economy. Securities are sold for the same reason. They deduct our purchasing power for a time so that the government can spend without over-inflating the economy. Interest payments are simply the transfer of savings to checking accounts. They "inflate" the economy, assuming it’s subsequently spent. Lack of spending deflates the economy.

So China can either keep the dollars they receive from selling us their goods in checking accounts or buy securities and earn interest on them. If they don't but the securities (our debt) then they don't earn interest. They might also choose to buy things with them but can only buy things for sale in US Dollars.

At the moment, inflation is not something to worry about. Rather, deflation is a much greater concern, as is the really high unemployment rate. Spending is what is needed. That does not mean it has to come from the government. Choosing the right size of government is independent of this "theory". As a nation, we should decide how much government we want in terms of defense, infrastructure, education, social assistance, etc. and then tax so that spending is enough to buy our output. Taxes should adjust in times of recession and growth, not government spending.

I hope this answers your questions. Please check out these vital resources for understanding how our nation's sovereign fiat monetary system works!!:

Warren Mosler's Seven Deadly Innocent Frauds
L. Randall Wray's Understanding Modern Money

Don't be fooled! We cannot go bankrupt! and we are not like European nations or even individual households! Too high deficits make their impact in inflation and exchange rates, which reduces the price of our goods relative to other nations' goods which boosts our economy's exports.

UPDATE: If you read this from the WSJ blog and think Modern Money is wrong, the key is that Congress voluntarily set a debt limit and can only voluntarily default on its debt. With control over its own currency it would be absolutely absurd to do such a thing.

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