Undoing of a reserve currency

Undoing of a reserve currency

Iam not a fan of “central banking"—and specifically of the currency debasement policies followed by the US Fed and the Reserve Bank of India (RBI). Central banks have been created for the very purpose of transferring wealth from the citizens to the government through “inflation tax", while pretending to be guardians of monetary stability. Even by the low expectations that I have of the Fed, its response to the subprime crisis has been stunning.

Consider the cutting of short-term interest rates first. When the Fed first cut interest rates by 50 basis points in September, I had argued the cut would do little to stop the collapse of the housing bubble. What had created the bubble in the first place was the combination of lax lending standards, initial teaser rates, speculative consumer behaviour and the packaging of these loans as “AAA" rated assets. Without these props, there was no way that housing prices could have remained at elevated levels.

Freezing of teaser rates: Technically, this was announced by the Bush administration and so maybe the US Fed is not responsible for this. The plan envisages a five-year moratorium on teaser rates for a certain category of subprime borrowers. To start with, there is the moral hazard of government bailing out speculators. Another issue would be how banks would implement the plan without encouraging more borrowers “to become poorer", at least on paper, to avail subsidy.

Lenders would now factor the additional risk of rate-freezing for new loans and this would lead to higher interest rates. With the declining dollar, it did not make much sense for foreigners to buy dollar-denominated debt in the first place, and the current unilateral rate-freeze and being held liable for defaulting borrowers adds to the risk of the holders of these debt instruments.

What this plan aims to achieve is to prevent homes from going into immediate foreclosure that would accelerate price declines. But there is no way to return to normal lending conditions without the accompanying normal housing prices. In effect, this plan would facilitate payments by the subprime borrowers a few more months before inflation in the underlying economy makes even these teaser payments difficult.

Low-interest loans to holders of MBS: The plan is to provide low- interest loans to the holders of these illiquid MBS, without the borrower having to publicly disclose his identity. This, however, is the old wine of helicopter money and it’s incredible to see how analysts believe the housing bubble, which is essentially a symptom of inflation, can be controlled by more inflation.

What this amounts to is a bailout of the banks that could be holding up?to $400 billion of these securities. But the losses have been incurred and there is nothing that the Fed can do to ensure that these MBS regain their valuations. All that the Fed can do is to determine as to who pays the bills of these excesses i.e., the banks or whether to socialize the losses. The current action is a mere monetization of these debts whose burden will now be shared by holders of the US dollar.

None of this newly created credit-from-thin-air will go back to the housing market. Most likely, we will witness the “Ben Carry Trade", where institutions find it convenient to borrow at 4% and invest in higher yielding as well as appreciating currencies.

Notwithstanding his thesis of helicopter money, I believed that when things really mattered, Ben Bernanke would stand up and do what is right for the US dollar i.e., maintain monetary integrity with real interest rates and curb money supply. After all, the privilege of the world’s reserve currency was something the US dollar had legitimately earned through decades of savings, investment and production resulting in trade surpluses. To see this hard-earned privilege being frittered away for sheer lack of conviction is sad.

This, however, would not be the first time that the world would witness such a transition. When we began the previous century, the British pound was the reserve currency and US was an emerging economy. Over the next 100 years, US became the predominant power driving the global economy through industry facilitated by low taxes and limited government. We have now come full circle: The gains have been nearly destroyed and all that’s left is an economy that boasts of consumption with borrowed money.

This time period in history should definitely mark the beginning of the end for the US dollar as the reserve currency. After all, the rest of the world now holds more than $14 trillion (and increasing by $1 trillion every 18 months) and there’s nothing that these foreigners can legitimately purchase using the same. It’s hard to fathom how the situation can continue even for a few more years, let alone indefinitely.

Shanmuganathan N. is director of Benchmark Advisory Services. Comments are welcome at theirview@livemint.com