Stephen King: Loss of trust in dollar could be euro's gain

The US may end up in the same degree of trouble as comes from persistently misleading your bank manager
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The Independent Online

Imagine a world where you need a bit of extra cash (at this time of the year, not a difficult task). You go along to your friendly bank manager and ask her to provide some help. She wants to know the purpose of the loan. You tell her it is for an exciting investment project. She agrees to the loan, you walk out of the bank, newly flush, and blow the money on a skiing holiday.

Imagine a world where you need a bit of extra cash (at this time of the year, not a difficult task). You go along to your friendly bank manager and ask her to provide some help. She wants to know the purpose of the loan. You tell her it is for an exciting investment project. She agrees to the loan, you walk out of the bank, newly flush, and blow the money on a skiing holiday.

Who has done well out of this arrangement? The ski chalet landlords, most obviously. But you have also benefited from your little white lie: you've had the skiing holiday, you've kept your family happy, and you've really only got to worry about the loan repayment. And, at these interest rate levels, you are not that bothered. The bank is fine so long as it does not discover what you've been up to - but if it does, it is not likely to be quite so keen to lend to you again.

Of course, if you were feeling really mischievous, you might also try to avoid repaying the loan in full. How might you do this? The most obvious way would be to default, although it would not help your longer-term relationship with the bank. What would happen, though, if you could hide the default, pretending that it had nothing to with you?

As individuals, we're not terribly well placed to do this. A default is a straightforward and often transparent affair. Collectively, though, defaults are relatively easy to engineer, at least in the short term. Most governments got away with it for a time in the 1970s when they allowed inflation to rise in an unanticipated fashion. Those people who had lent to governments - bondholders of one sort or another - suddenly found themselves with rapidly eroding real asset values. This "inflation tax" benefited borrowing governments at the expense of those that had given those governments their savings.

Of course, governments couldn't do this forever. The high inflation of the 1970s was replaced by the high real interest rates of the 1980s as markets became a lot wiser. No longer were they prepared to deposit their savings with governments that had, for too long, placed short-term political expediency ahead of the longer-term interests of savers. Governments were eventually forced to deliver massive fiscal consolidation year after year, associated with the Gramm-Rudman Act in the US, the Medium Term Financial Strategy in the UK and, later on, the Maastricht treaty in the eurozone.

Lenders now felt a lot safer. With fiscal consolidation and the arrival of independent central banks, the risk of losing your financial shirt appeared to have fallen. Now, we could believe that a loan would not be frittered away on a ludicrous public sector venture but, instead, be subject to the rigours that, previously, had applied only to the private sector.

Or so we all thought. Governments and policymakers may have finally learnt to respect their domestic savers but it is a lot less obvious that they have done the same for others. With the growth of international capital markets, governments now have a responsibility that transcends borders. Of course, governments can choose to ignore those responsibilities - after all, it's only nationals who vote in elections - but, by doing so, there will eventually be a market reaction.

The dollar's vulnerability at the moment is, perhaps, only the first sign of that market reaction. But it seems to me that, over time, the US may end up being in the same degree of trouble that comes from persistently misleading your bank manager: when the foreign creditors find out what has been going on, they will be a lot less inclined to lend to the US.

There are two reasons for lending to the United States. The first is that you expect returns there to be higher than elsewhere. When the new economy was all the rage in the late 1990s, money flooded into the US precisely on this basis. The second is that you believe that the US dollar represents a useful store of value, better than other currencies. Why might you think this? Because, ultimately, the dollar is the world's reserve currency.

Asian central banks know this. Their reserves are held mostly in dollars. Middle Eastern oil producers know this because their oil is priced in dollars. Latin American commodity producers know this because their raw materials are sold in dollars.

Rightly or wrongly, people basically trust the dollar. America's capital markets are deep and liquid. America has been a model of economic transparency and of generally good corporate governance over the years. People are happy to hold dollars because, of all the currencies in the world, it seems to be the one best able to provide longer-term security. It is, if you like, the nearest paper equivalent to gold.

It is precisely because of this trust that the US can get away with behaviour that other countries can only dream about. If your bank manager trusts you to invest the loan in a business, it doesn't really matter too much in the short term whether that trust is justified. And, if you can get away with spending the money on some consumer frippery on one occasion, you might just do it again and again.

That's what the US has been doing over the past few years, building up more and more foreign liabilities without fully investing the money in productive assets. Too many skiing holidays, if you like, at the expense of productive investment.

This, however, is an abuse of America's reserve currency status not too dissimilar to the excess government borrowing and inflation of the 1970s. The difference, this time around, is that the immediate victims are not America's direct responsibility: they are the foreign creditors who placed their trust in the dollar when nothing else seemed particularly attractive.

This abuse of trust can cause lasting damage. At the beginning of the 20th century, sterling, not the dollar, was the world's reserve currency. But as the century progressed, so sterling lost its status, hit by Britain's relative economic decline, the burdens of two world wars and an apparent inability to deliver price stability in the late 1960s and early 1970s.

No currency has a God-given right to maintain its reserve status forever. Countries have to work hard to hold that position. A failure to do so implies a loss of trust, a downgrading of status by international investors, reducing a country's ability to access global capital markets, thereby increasing the cost of borrowing.

Up until now, the US has had very little to worry about because no other currency could offer the same liquidity, depth of capital markets and trust that the dollar provided. That may no longer be the case. The euro is an interesting alternative unit of account and store of value. And maybe in time Asian currencies will be also, perhaps leading to the formation of an Asian currency bloc.

So why stick with the dollar? Take a look at the charts. They show the price of gold and the price of non-precious metals over the past 10 years using both dollars and euros. Whichever way you look at it, the euro has provided the more stable benchmark. Perhaps, therefore, the euro provides ultimately a better store of value for international transactions. If so, the ultimate cost of America's persistent visits to the bank manager could prove to be a lot higher than the majority of Americans recognise.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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