I tried to answer your question with my last post. I do agree that the fed lost control of the dollar system through the crisis. But I believe that they are now back in control due to the collapse of credit markets. The fed is the only source of financing to the credit markets in dollars right now. There is no threat of inflation due to the fact that the fed could call in their credit within minutes and affect the financial system much more quickly than before. The level of accomodation by the fed is very much affected by the level of cooperation by other central banks. The fed policy makers will not tolerate another threat to the dollar system. If the fed sees problems arising within the dollar markets again, they have much more ability to correct them quickly now, than say last year. In order to preserve the dollar standard, the fed wants dollar reserves to be much lower worldwide in the next decade. There are only 3 ways to do this. Debase the dollar, contract the dollar supply, or force the dollar holders to spend the resesrves. It seems the fed is going for debasement, which encourages dollar holders to also spend it. The Chinese are over a barrel now. That's why they keep complaining about the dollar. They can't do anything to save their reserves from debasement, except to spend it quickly. They have been trying to lobby Washington to stop spending as much. You have seen Washington responding favorably to their request as recently as today with the new Paygo legislation. Washington's out of control spending put the dollar standard at risk, so you will see a lot of changes in the US government in the next few years. Since the fed can't contract the money supply due to the US economic problems, the fed has encouraged the chinese to spend their reserves to boost domestic consumption. That's where you see the Chinese cooperating with their economic stimulus package. The Chinese don't like having so many dollars, so they are obliged to cooperate since the spending is a direct investment on their country's infrastructure. The risk is, the Chinese economy will become dependent on government stimulus to continue growing longer term. In 5-10 years, after they have blown their dollar reserves, will they become a debtor nation? In my opinion, that is exactly what the Fed policy makers are betting on to restore long term order in the dollar system. I used china as the example, but this can be applied to many other holders of dollar reserves. Russia, oil producing nations..etc.
Is there a scenario wherein the Fed could not absorb enough, quick enough and inflation could run away?
Great post Pascal, you've really got a broad knowledge of macroeconomics. I also tend to agree with Martin though, that most things are not quite so conscious and many factors create collective decisions. I'll throw in another take on China. I think many in the government there were aware from the beginning that they would lose big by buying treasuries. However, they gained something even bigger - usurping America's manufacturing base and gaining political clout over US policy as a secondary benefit. At this point it will be difficult for the US to regain a dominant manufacturing position. The Fed and financial industry can play whatever tricks they want, but China knows that true power ultimately comes from production, not money games. Eventually I see Russia, China, and oil producers accelerating their current moves toward gold and commodiity backed currency. Then the US and Europe will be left out in the cold and China will have peacefullly transitioned into becoming perhaps the dominant world power.
I don't know why people think that moving to a gold standard is the right way to go - isn't there a limited amount of gold in the world? Wouldn't this result in a limited amount of money? If population continues to grow, doesn't that mean less money to each person and incomes/wealth etc., continually decline?
Exactly. Plus, commodity based currencies are just as prone to boom and bust cycles as fiat currency systems. You still have credit in a gold standard. The bigger problem with a gold standard is the inability to increase the money supply in the bust phase of a credit cycle, which really hurts the poorest in the world. Plus it endangers the political system of countries by making them vulnerable to populist political movements that can undermine longer term prospects. The benefit of a gold standard is that it inflicts discipline on governments by restraining monetary expansion. But throughout history, the gold standard never worked the way it is romanticised today. There were always hybrid systems mixed with gold and fiat money. So, it never really had the benefit that is preached by the gold bugs.
A balanced budget amendment would work much better then a Gold standard when it comes to discipline by governments.
I don't follow your logic. Why was China and Russia dumping their treasuries a legitimate threat back then, but no longer today? What's different?
That was a very interesting post Pascal. I may have to re-read that once or twice. Didn't think about the sunday night net-out in that manner. Good point. I've posted before that the oil superspike was abruptly reversed following Russia's invasion of Georgia in the South Ossetra action of 2008. Can't let the russian bear have that much power again, so the bottom needed to fall out of that market. Whether that had 'unintended consequence' that led to the LEH collapse is a job for the financial historians to figure out. Add the Kanjorski statements to tie things together as well.
Thank you for your posts Pascal. They have been very thoughtful and informative. Could you please post your thoughts for how the next 5-10 years (or even longer) play out? Obviously no one can predict the future, but I'm curious as to what you see in regards to, as you say the "dollar, treasuries and reserve currency" in the future.