Detailed opinion editorial by Niall Ferguson in Australian Financial Review quotes De Gaulle's 1965 warning about the use of the US dollar as an international reserve currency and proceeds to describe how current US economic policies are primarily underwritten by central banks (especially in Asia) holding US dollars as reserve. Substantial increases in US interest rates combined with increased use of the euro as a reserve currency could result in significant hardships to un-hedged debtors in the US, primarily the US government and private homeowners. This is not necessarily a calamity, but it would have serious effects, most notably a slowdown in the US economic recovery.
This rapid role reversal - from world's banker to world's biggest debtor - has had two advantages for Americans. First, it has allowed US business to invest substantially (notably in information technology) without requiring Americans to reduce their consumption. Between 10 and 20 per cent of all investment in the US economy in the past decade has been financed out of the savings of foreigners, allowing Americans to spend and spend. The personal savings rate is less than half of what it was in the 1980s.
The second pay-off, however, has taken the form of tax cuts rather than private sector investment. The dramatic shift in the finances of the federal government from surplus to deficit since 2000 - a deterioration unprecedented in peacetime, according to the IMF - has been substantially funded from abroad. Had that not been the case, the combination of tax cuts, increased spending and reduced revenue that has characterised George Bush's fiscal policy would have led to much more severe increases in long-term US interest rates. Veterans of the Nixon and Reagan years can only shake their heads enviously at the way the present Republican administration has escaped punishment for its profligacy. To run deficits on this scale while enjoying long-term bond yields of under 5 per cent looks like the biggest free lunch in modern economic history. The cost of servicing the federal debt has actually fallen under Bush, even as the total debt itself has risen.
The reason is simply that foreigners are willing to buy the new bonds issued by the US treasury at remarkably high prices. In the past 10 years, the share of the privately held federal debt in foreign hands has risen from 20 to nearly 45 per cent. Just who is buying all these dollar-denominated bonds, apparently oblivious to the possibility that, if past performance is any indication, their value could quite suddenly drop?
The answer is that the purchases are being made not by private investors but by public institutions - the central banks of Asia.
Between January 2002 and December 2003, the Bank of Japan's foreign exchange reserves increased by $US266 billion. Those of China, Hong Kong and Malaysia rose by $US224 billion. Taiwan acquired more than $US80 billion. Nearly all of this increase took the form of purchases of US dollars and dollar-denominated bonds. In the first three months of this year alone, the Japanese bought another $US142 billion. The Asian central banks' motivation for doing so is simple: to prevent their own currencies from appreciating relative to the dollar - because a weak dollar would hurt their own exports to the mighty American market. Were it not for these interventions, the dollar would certainly have depreciated relative to the Asian currencies, as it has against the euro. But the Asian authorities are willing to spend whatever it takes of their own currency to keep the dollar exchange rate steady.
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