Wanna know why US remains the world’s largest debtor nation?

The United States of America is the world’s largest debtor nation. It’s a borrowing binge that just does not seem to end. The question is, how does the US do it?

“It’s all part of a virtuous cycle that has been powering the global economy for the past ten years. Asian economies have kept their currencies cheap, making their goods inexpensive and boosting their sales to the United States,” says Craig Karmin of The Wall Street Journal. He explains the whole thing convincingly in his new book, Biography of the Dollar - How the Mighty Buck Conquered the World and Why It’s Under Siege.

American consumers, he said, have responded by buying Asian products—cars, apparel, electronics, and so forth. In effect, Americans are sending their savings abroad. This creates a surplus of dollars in Asia that central banks there invest back into the United States through purchases of treasury and other US bonds.

“That starts the cycle all over again: keeping interest rates down and loans cheap for Americans, who can also continue to borrow and spend. American companies can also borrow in the corporate bond market at cheap rates because their borrowing costs are priced off the low treasury market yields,” he said.

In this interview with Vivek Kaul he explains how the US dollar became an international currency, the impact its movement has on oil prices and what is its likely future.

What are the factors that were responsible in making dollar an international currency?
Historically, nations with the largest economies or the ones that were most active in global trade enjoyed international use of their currencies. But initially, that was not case for the United States. At the start of the twentieth century, the US had the largest economy and was one of the world’s biggest traders. Yet no one outside of North America used the dollar.

Why? Astonishingly, America had no central bank, no lender of last resort to support the financial system and defend the currency. That discouraged foreign banks from holding it.

That problem was solved with the Federal Reserve Act of 1913. The outbreak of World War I the next year led European allies to turn to New York banks for loans. The Europeans were told they could borrow in dollars. By the end of the war, the greenback was well on its way to challenging the British pound for global dominance. The transition was completed in 1944, when the major nations of the free world signed the Bretton Woods agreement that stated that only the dollar would be pegged to gold, and all other currencies would be linked to the dollar.

It was an unprecedented event. While the pound, Dutch gilder, the Chinese liang and the Islamic dinar all had experienced international use over the past 2,500 years, never before had world’s powers formally agreed that there would be just one currency among which all others would be measured. Perhaps even more amazingly, even after President Nixon torpedoed Bretton Woods by taking the dollar off the gold standard in 1971, its use grew even wider. People were just as eager to hold dollars backed only by the full faith and credit of the US government as they were dollars backed by gold.

What have been the positive impacts of the US dollar becoming an international currency? 
For Americans, the benefits are many. Washington can run budget deficits, then borrow money from foreigners (who have been happy to hold dollars) to bridge the difference. Because the US companies can borrow anywhere in the world in their own currency, they don’t face the kind of dilemma Asian companies faced in the 1990s. When their own currencies collapsed against the dollar, the local-currency value of their debts soared, forcing many into bankruptcy. Even individual Americans benefit from the lower interest rates they enjoy for cars and homes because the demand for dollar-denominated debt globally has kept US rates down.

But there are benefits to the rest of the world, too. When companies transact in one major currency (whether it’s the dollar or another one that’s widely used) trade costs come down because companies don’t have to repeatedly convert back and forth between different currencies.

Some countries have stopped printing their own currency and started using the dollar. How does it help?
In 2000, Ecuador, the poor South American country, was facing crippling inflation and massive currency devaluation. In what could only be described as a desperate move, the government announced it was abandoning the local currency, the sucre, and would henceforth use only the US dollar. That move was so unpopular that the president was immediately overthrown in a coup. But to most people’s surprise, his successor went ahead with the dollarisation plan.

While the transition was wrenching, the relative stability of the dollar began to bear the positive effects Ecuador had hoped for. The annual rate of inflation shrank from nearly 100% to less than 2% by 2004—the lowest inflation rate the country had seen in generations. The dollar’s stability and low inflationary backdrop meant that banks could resume lending and the middle-class was able to borrow again to buy cars and appliances for the first time in years.

But dollarisation didn’t come without a price. Ecuador, in effect, outsourced its monetary policy to Washington. It no longer has the ability to set interest rates (local rates are set by private banks, not the government) and it cannot weaken its currency to make its products more competitive. Ecuador has also been very fortunate in that it is an oil exporter, and the price of crude has skyrocketed. Since oil is priced in dollars, it has ensured that the country has enough greenbacks coming into the economy to keep it running. A collapse in the price of oil would make it hard for Ecuador to raise enough dollars, since it can’t print them. It’s also raised questions about whether other countries - those without a high-priced export like oil—could follow Ecuador’s example. El Salvador dollarised in 2001, but as the health of currencies in most of Latin America have improved in recent years, no other countries in the region have followed.

The dollar has depreciated against other major currencies, and the price of oil has gone up substantially. Can you explain the link between the two…
The link began in the 1970s, when the dollar was falling and the OPEC countries decided to cut back on supply of oil. They succeeded in a quadrupling price of oil. While clearly the move reflected Middle East politics and an effort to punish the western nations that supported Israel, OPEC members also felt they deserved compensation for the weaker dollar. Since oil is priced in dollars, a weaker currency means that they received less real value for their commodity —- that they could buy fewer things in yen, marks or francs.

North Korea has been counterfeiting the greenback for some time now. How do they do it? You have written that ‘Super Notes’ even appear to be of superior quality to genuine dollars. What’s  the US doing to tackle this?
There’s still not a lot known about North Korean counterfeit operations, and what the secret service (the government agency that tackles counterfeiting) does know, it’s not often in a position to make public. What is generally agreed upon is that the first so-called Super Note—phoney hundred dollar bills that strikingly resemble the real thing—were first detected in 1989 at the Central Bank of the Philippines. While the bill passed the usual authenticity tests, a money handler thought something didn’t feel right and sent it to the US Secret Service. After putting the Super Note under ultraviolet light could the agents determine it was a counterfeit. 

That incident kicked started a US government plan to redesign all its bills but the $1, starting with the $100 bill in 1996—the first visible change to American currency since 1928. The government added new security features like watermarks and colour-shifting ink, so that merchants could look for these items whenever they doubted a bill’s authenticity. Such moves were considered crucial to maintaining the credibility of the dollar and the willingness of people around the world to accept it.
 
How does dollar being the international reserve currency help the US borrow an increasing amount of money from foreign lenders?
When most governments need more money for a new programme or service, they face a tough choice: raise taxes, cut back on other programmes, or borrow that money. Borrowing is often the most tempting and politically expedient choice. But typically, the more a country borrows, the higher interest rates it must pay. Eventually, additional borrowing becomes prohibitively expensive and the mounting debt takes a toll on the economy.

The US, for the most part, has been able to avoid this dilemma. Because foreign lenders are eager to hold dollar-debt, Washington can continue to borrow without foreign creditors demanding higher rates. East Asian governments have been particularly obliging. They like to keep their currencies cheap in order to boost their exports to the US. The money they get from sales of cars, electronics, apparel and other goods is invested back into the US through large purchases of US bonds. That starts the cycle all over again, keeping interest rates in the US low even as it debt total rises.

How long do you see this high borrowing going on? Don’t you think the world is getting wary of holding more and more dollars. Moreover, once that happens, America and Americans cannot keep borrowing?
That’s one of the most important questions facing the global economy. No one knows when Asian and other foreign creditors will decide that they can grow their economies without relying primarily on a cheap currency and exports to America. But we seem to be moving gradually in that direction. Nor is it clear when the world will see America’s mounting debt as too high. Already, the US pays about $300 million a day in interest payment on its foreign debt. But when the day of reckoning comes, creditors will start to demand higher rates to lend to the US, just as they do with other countries.

Do you think this will lead to the dollar losing its status as the international reserve currency? Why do you think that is happening?
Over time, international use of the dollar has nowhere to go, but down. The euro is the greenback’s first genuine competitor since Bretton Woods in 1944. Many emerging markets have ended their direct currency pegs to the dollar. Moreover, global investors no longer demand that all developing countries borrow in dollars. Many currencies in Asia, Latin America and Eastern Europe are now seen as stable enough for nations in those regions to borrow in their home currencies. So, the unprecedented role the dollar played in the post-Cold War global economy probably peaked sometime in the 1990s. The dollar’s dominance is being chipped away, but only gradually. Indeed, the European Central Bank recently said that the euro’s share of global foreign-exchange reserves actually “fell” in 2007. While that surprised many people who have already written the dollar’s obituary, it shouldn’t have. Shaking the dollar loose from its place at the centre of the global economy would require a vast reworking of trade and financial relationships that have developed over decades and that few parties seem ready to confront, at least not yet.

 k_vivek@dnaindia.net