Thursday, September 27, 2007

Global Reserve Currency

You are the Finance Minister of Agoraphobia, a country with a relatively well-off population of 25 million people. Your country is not a member of the EU, or any other currency bloc and your President just asked you to give him a report on the Treasury's holdings, with particular emphasis on which reserve currency Agoraphobia should hold, since its own is not a major one.

You start and at some point your report will include something like this...

Desired Attributes of Our Global Reserve Currency.
  1. Holds its value quite well against other currencies, particularly major ones that account for large shares of our country's global trade.
  2. Holds its value very well against things we need to buy from the rest of the world (e.g. oil, food, machinery, consumer goods).
  3. The state that issues it must produce or provide quality goods and services we may need or wish to buy, so that even if it loses value against other currencies we can still use it directly.
  4. The state that issues and backs it must exhibit political and economic stability and behave rationally towards the rest of the world.
  5. The state that issues it must be firmly committed to the free movement of capital between borders, with relatively few - if any - regulatory hassles.
  6. The state that issues it must exhibit relatively low levels of foreign debt vs. its GDP, to minimize the chance that it will be tempted to inflate away its obligations or default selectively on its foreign debt.
For the above reasons, Mr. President, our Ministry has recently chosen the Eutopian Romeo as our major global reserve currency. As you also know, we used to hold mostly Usorian Dinkies, but it gradually came to be that it satisfied only 1 (one) of the above 6 (six) major requirements, so we switched. A smart decision, if I may say so myself, Sir.

Always At Your Service,

Dagny Taggart

Minister of State for Finance


  1. Is European debt low?

    I thought France is running huge deficit and Europe is facing pension crisis.

    British Pound seems to be a more reliable currency at times.

  2. I thought France is running huge deficit and Europe is facing pension crisis


    As a French person, may I give a short answer on France...

    An economic and financial one. Not a political item. I hopd the debate does drift into pointless polemics.

    On the one hand France central authorities (aka government and associated entities) are fairly indebted, at a level that compares to the US.

    The current deficit is around 40 to 50 billions Euros and we now run an external trade deficit (our exports do cover only 90% of imports).

    ON THE OTHER HAND, The French middle class tend to save a relative high portion of its revenues. Sparing is an important but undervalued item.

    The overall balance sheet for the country is not great. Clearly not what it used to be but external accounts are still on the plus side.

    But please give pay attention the whole picture when refering to countries such as UK, US and Spain.

    GPD is a widely missleading health index. It's more of a weight index than a health one.

    The external figures for our neighbour, Spain, are now bordering to insane with PRIVATE DEBT RUNNING TO THE ROOF.

    I'm fairly disappointed by this common idea that public debt is evil and private debt is ok.


    Let us take money!

    Private AND public debts should always be under control and public scrutiny. BOTH OF THEM. Especially when the private debt does not provide signicant long-term advantage to the country.

    This view that private debt is not harmful is plain stupid.

    It has allowed the above-mentionned countries to enter a wide asset-bubbling ponzi-scheme that will unravel in a horrendous manner.

    This is no political argument. Just an assesment of accounts.


  3. I agree that debt must be viewed on the aggregate, i.e. public+private. Furthermore, one needs to look at the structure (long term vs. short term, fixed vs. variable, internal vs. external, etc.), plus the use of the borrowed capital.

    Europe is facing a pension crisis, but so is the US - though it is tilted more on the medical benefits side. The Comptroller General is tearing his hair out (and he doesn't have much to begin with), touring the US trying to warn people that the unfunded liabilities for Medicare and Social Sec. are colossal. Baby Boomer retirement is going to make things VERY tough.

    And though the UK is not part of the eurozone, it is part of the EU. Sooner rather than later they will have to adopt the euro.


  4. What if Agoraphobia is, to a significant degree, economically dependent on Usoria to the extent that 40% of Agoraphobia's exports go there? And so it is constantly receiving a stream of Dinkies in payment. Also, many essential commodities it must buy, e.g. oil, are priced in Dinkies. Will switching abruptly to Romeos 'bite the hand that feeds it', so to speak? Also, what if Usoria is the leading member of an important security/military alliance that also includes Agoraphobia? Would such a switch be politically wise for Agoraphobia? So perhaps any such decision by Agoraphobia will not be so straightforward.

    Regarding SS 'liabilities': no one has any kind of legal claim on SS benefits -- the courts have quite plainly ruled on this several times. And this includes people who have paid the FICA withholding tax. Because that's all it is: a tax. And payments funded by this tax are set by Congress. So Congress can just change the law. Of course politically it is not so simple.

    It would be much better to phase out SS in favor of some sort of privatized scheme along the lines of a 401k/Roth IRA with employer matching and favorable tax treatment for additional employee contributions. Add to this a means tested welfare system for the elderly. (Health care is a separate problem.) As it is now, the average middle class worker pays more into SS than he gets out of it after he retires (meaning the return on all of those contributions is negative), and the income subject to the tax is capped at a fairly low level; I don't see how such a system is fair or defensible.


  5. Agoraphobia is obviously an extreme example. But the basic attributes obviously stand. The US dollar is in trouble in many ways - all of them fundamental and structural in nature.

    A weak dollar is an enormous mistake and will cause huge friction with China, because eventually (or even sooner) politicians will take the "direct" way out and just slap an across the board import duty on all Chinese products. It may be the only "out" we have right now, but it is still the wrong decision.

    By the way, all the publicity about Chinese product recalls, babies dying... sounds like preparing the ground to me.

  6. The British Pound will be in trouble once the revenue stream from the North Sea oil fields dries up. That's what's been keeping the Pound afloat for the last few decades.
    Toxic financial products made in USA coupled with a deteriorating $ will cause many exporters of goods and raw materials to demand payment in anything but $$. See Russia, Iran and Venezuela. Others soon to follow.

  7. François,

    Don't worry. This is no political argument. I am just wondering about it. That is all.

    Thanks for info!

  8. Several months ago, I entered a comment in The Oil Drum. Basically it said this: If you see the Saudis breaking their currency's hard peg to the dollar, run for the hills.

    Something is cooking over there now. Does anyone know if they eventually lowered their own short rates after the Fed cut? Or are they still holding out at 50 bp higher?

  9. Sounds like the Euro to me.

    But I think the right solution is a mix of many currencies, the more the better. Even private investor can collect pretty much all major currencies/bonds - why is that so complicated for central banks?

  10. Dear "Hellasious",

    I wonder if you could interpret something for me.

    Please go to the IMF's Global Financial Stability Report at

    Click on the "Statistical Appendix," and open the PDF file.

    Go to page 136, and look at the "TOTAL" line in table 4. Here's what you find:


    Table 4. Global Over-the-Counter Derivatives Markets: Notional Amounts and Gross Market Values of Outstanding Contracts

    (In billions of U.S. dollars)

    ................................. Gross
    ................. Notional ... Market
    .. Date ....... Amounts .... Values
    ----------- . -------------------------
    31-Dec-2004 . . 257,894 .... 9,377
    30-Jun-2005 . . 281,493 ... 10,605
    31-Dec-2005 . . 297,670 .... 9,749
    30-Jun-2006 . . 369,507 .... 9,936
    31-Dec-2006 . . 415,183 .... 9,695

    FOOTNOTE: All figures are adjusted for double-counting. Notional amounts outstanding have been adjusted by halving positions vis-à-vis other reporting dealers. Gross market values have been calculated as the sum of the total gross positive market value of contracts and the absolute value of the gross negative market value of contracts with non-reporting counterparties.

    ** END TABLE

    This says that at the end of 2006, there were $415 trillion (notional) in credit derivatives globally, and it also appears to say that the market value of is only $9.6 trillion. Is that true? Or does the computation of "Gross Market Value" mean something different?

    If it's really $415 trillion notional and only $9.6 trillion market, then "mark to market" is going to have a much greater effect than people have been saying.

    By the way, are you going to complete your evaluation of the stock market based on the effects of credit default swaps? I'm interested in seeing what your "bottom line" will turn out to be.



    John J. Xenakis
    Web site:

  11. But I think the right solution is a mix of many currencies, the more the better.

    Agoraphobia would rule out countries without liquid or open markets. Out goes the RMB.

    They would want to rule out countries with a history of defaulting on debt. Out goes most of South America, Africa, and Russia.

    It would want to rule out countries with crazy public debt ratios. Out goes the Yen.

    It would want to rule out countries that are at risk of collapse, revolution, or invasion. Out goes most of the middle east.

    If it has large reserves, it would want to rule out countries without deep public debt markets. Out goes Canadian Loonie and the Swiss Frank.

    What's left? The US and the Euro.

  12. Re: notional and market values for derivatives.

    These are ALL OTC derivatives, not just credit derivatives. They include FX swaps, outright forwards, currency swaps, interest rate swaps, pollution derivatives...huge variety.

    (The CDS market itself was around $35 trillion at end 2006, must be quite a bit more now.)

    But I think I understand what you refer to: the RATIO of notional to market has gone from 27x to 42x in two years. This is scary and that's what I have been calling the derivativization of the global economy.

    Part of it has to do with the explosion of CDS's which by design have very big notionals but small premiums. But you are right, overall: a lot of risk is being "hedged" for too small a price.

    The third installment on CDS's is ready - will probably run it on the weekend.


  13. Hellasious,

    FYI . . .

  14. Hellasious,

    Explain something to me if you can....

    The public debt of the US is backed by the tax base and GDP of the entire nation while the public debt market of the European Union is fragmented.

    If Agoraphobia were to invest its reserves in the public debt of all EU countries, how does it protect itself from a loss of principal if one of those countries were to default?

  15. Re: possible defaults of euro countries. being very careful which countries' bonds it invests in. I could also talk about the Maastrict Treaty and the penalty process of the EU clamping down on countries that run deficits over 3% of GDP etc etc, but statistics are bent out of shape everywhere to fit the necessary "shoe".

    Of course not all EU members are in the eurozone.

  16. drpi,

    Thank you for the link to the Business Week article. Interesting reading, indeed.

    And the Mishkin Fed paper is very valuable, too.

    Many thanks

  17. "The state that issues it must exhibit relatively low levels of foreign debt vs. its GDP, to minimize the chance that it will be tempted to inflate away its obligations or default selectively on its foreign debt."

    Interesting what this screen turns up*. Some examples:

    China - 3%
    Singapore - 17%
    Malaysia - 18%
    Japan - 37%
    Canada - 58%

    All of these have current account surpluses as a percentage of GDP ranging from 2% (China and Canada) to 25% (Singapore).

    * Used information from CIA Factbook

  18. "Dagny Taggart
    Ha! Great name....pls enlighten me as to your creative inspiration.



  19. Hellasious, what do you make of this article?

    In Canada, the ABCP was used to fund CDS positions!


    Credit crisis 'made in Canada'
    Lax rules blamed

    Thursday, September 27, 2007

    Canadian banks are struggling to contain a credit crisis that could spiral out of control here more than it has elsewhere because of a lax regulatory regime, sources have told the National Post.

    The crisis relates to the market for a complex type of short-term funding known as asset backed commercial paper (ABCP), which had grown out of proportion in this country partly thanks to Canadian rules that were not as tough as in other nations.

    Canadian investment bank Coventree Capital Inc. became one of the first major victims of the global credit crunch when it was unable to trade the ABCP it was holding because of the general seizing up of credit markets around the world.

    Following Coventree's collapse, Canadian non-bank owners of $40-billion of troubled asset-backed commercial paper -- pension funds and corporate treasury departments -- were forced into an unprecedented joining-of-forces known as the Montreal Accord to try to salvage their holdings.

    If the Montreal Accord does not result in a long-term agreement on how to resolve the issues in Canada's non-bank ABCP market by an Oct. 15 deadline, there could be a carryover effect on the demand generally for ABCP, said Blackmont's Mr. Smith.

    "Failure to fully restore investor confidence levels could reduce demand ...which could restrict the future ability of banks to manage capital," he said.

    Mr. Smith calculated that Canada's big six banks are on the hook for total liquidity facilities worth $135-billion.

  20. As a resident of Usorian I would like to know where my fellow Usorians are investing their Usorian Dinkies.

    Cash is King rings hollow when my dinkies are becoming dinkier.

    Perhaps the answer lies in emulating rich Usorians such as the honorable Buffetable and putting my dinkies in overseas stocks and bonds...

  21. Kicker said...

    What's left? The US and the Euro.

    Er, UKP?

  22. Anonymous (eh):

    It would be much better to phase out SS in favor of some sort of privatized scheme along the lines of a 401k/Roth IRA with employer matching and favorable tax treatment for additional employee contributions.

    I think this would be the worst possible scenario because of the problem of Chapter 11 bankruptcy.

    I take the exact opposite position. We need to expand Social Security into a full pension program. The only other way to deal with the problem is to make pensions and healthcare benefits priority debts in bankruptcy proceedings.

  23. Re: Dagny Taggart

    She is one of the main characters in "Atlas Shrugged" by Ayn Rand. This is a circuitous reference to Alan Greenspan who is great believer in her teachings.

    All about individual responsibility, no bailouts, etc etc.

  24. okielawyer,

    I read your material and appreciate your point of view. I like your suggestion that the rules governing SS income/contribution limits be changed so that high income people pay more -- this would make the system fairer, and indeed I mentioned this.

    Still I disagree with your basic idea of expanding SS.

    I'm an American, but have lived in Europe for almost 10 years now, in a country with just such a universal pension system. Before this experience I worked for 20 years in the US, paying FICA taxes, but also funneling the maximum into 401k plans and IRA accounts whenever I could (the ability to do this ought to be greatly expanded).

    So I have firsthand experience with both.

    And it is this firsthand experience that has led me to say a universal pension system is a bad idea. IMO it provides a disincentive to save. As a worker, you are forced to subsidize the lives of other people who, due to their lifestyle choices (which you might not approve of), may have saved little or nothing for retirement, and whose earnings, or lack of them, are also due, in large measure, to their life choices (e.g. spending more time smoking than reading).

    Sorry, but I just don't want to do that.

    Such a system breeds dependence on the government and its coercion of taxes.

    I guess I have a libertarian view of this. People ought to be given the opportunity to save on their own, as much as they want. Minimize the role of government, as far as possible.

    Also, I think the 'contract of generations' that underpins this system is absurd. The main reason European governments decry low birthrates is they need future workers/taxpayers to pay the pensions of the retired, Ponzi-like.


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