The Credit Crisis - Is the International Role of the Dollar at Stake?

Ramaa Vasudevan

As the first tremors of the looming financial crisis ripped through Wall Street, with the meltdown of the subprime mortgage market in the summer of 2007, the dollar plunged sharply. Perversely however, even as some financial pundits were foretelling its collapse, the deepening of the crisis following the bankruptcy of Lehman Brothers in September 2008 actually saw the dollar gain ground sharply (for the first time since the steady decline that began in 2002; see chart 1).1

Chart 1. Nominal major currencies dollar index

Source: Federal Reserve, "Nominal Major Currencies Dollar Index."

For any other country a financial crisis of this magnitude would have sparked a full-scale currency crisis. Why then has the deepening of a crisis centered in the United States actually seen the reverse, the strengthening of the dollar? The answer lies in the continuing role of the dollar as international money.

In “Finance, Imperialism, and the Hegemony of the Dollar,” in the April 2008 issue of Monthly Review, I argued that the privileged role of the dollar as international money has been critical to U.S. imperialist hegemony. The explosion of private financial flows globally helped the United States preserve and establish its pivotal place at the center of the international financial markets and impose a “dollar standard.” However, this process also created the conditions for its own unraveling. The present crisis, an outcome of this unfettered growth and rising dominance of finance, lays bare the contradictions of the mechanisms of the dollar standard.

Two developments summarize the process so far: (1) When panic hit, the U.S. dollar’s status as “international money” asserted itself, and the dollar rose against all currencies other than the yen. (2) The implosion of the financial system, however, has threatened the foundation of dollar hegemony—its central role in the proliferating web of global private capital flows. The current crisis is thus also potentially a crisis of dollar hegemony.

Dollar Hegemony

The Bretton Woods negotiations at the end of the Second World War paved the way for establishing the dominance of the dollar as international money. This role was sustained by the confidence that the United States with its vast reserves of gold would honor the commitment to provide gold to foreign central banks in exchange for dollars at a fixed rate of $35 per ounce. By the end of the sixties, the growing trade deficit and the burdens of its military interventions in Vietnam created a huge dollar overhang abroad. In the face of increased demands for gold in exchange for dollars the United States unilaterally abandoned gold convertibility. This, however, did not lead to the dismantling of dollar hegemony. Instead, the refashioning of the international monetary system into a “floating dollar standard” in the post–Bretton Woods period was associated with the aggressive pursuit of liberalized financial markets in order to encourage private international capital flows denominated in dollars.

In the 1970s the Eurodollar markets served as the principal means of recycling oil surpluses from the oil exporters to developing economies, particularly in Latin America. This process became a tool of resurgent U.S. political dominance. The 1970s military dictatorships in Chile, Indonesia, and Argentina, and the “Chicago School” free market regimes that followed, were bolstered by repression and supported by the readily available loans from U.S. banks flush with oil funds. Once this cheap bonanza of credit came to an end with the debt crisis in 1982, a new wave of neoliberal reforms and financial liberalization was imposed through the IMF–World Bank rescue packages. The crisis was deployed to further entrench the dominance of the dollar and U.S. imperialist agenda. In country after country the IMF and World Bank imposed “structural adjustment” policies during the crisis phase that destroyed all attempts at independent economic development while engulfing their financial systems in the ambit of dollar hegemony.2 This set in motion another surge of dollar denominated private capital flows to emerging markets and a fresh round of crisis in the 1990s when capital flowed back to the United States.

Chart 2: Private capital flows to the United States and to emerging markets (billions of dollars)

Source: U.S. Bureau of Economic Analysis, Global Development Finance.

From 1973, up until about 2003 (the run-up to the present crisis) the periods when flows to emerging markets surged were also periods with a net efflux from the United States. As the surge comes to an end in the wake of capital flight and crisis, as in the Latin American debt crisis in 1982–83 and the Asian crisis in 1997–98, private capital flows are sucked back into the United States (see chart 2).3

The privileged role of the dollar provided the United States with an international line of credit that helped fuel a consumption binge. Cheap imports allowed consumption to be sustained despite stagnant or declining real wages. The export-led economies of Asia (first Japan, later East Asia and China) in turn depended on mass consumption in the United States to drive their economies. But the dependence on cheap imports precipitated growing trade deficits. Unlike other deficit countries the United States could, because of the dollar’s role as international money, finance its growing deficits by issuing its own debt in the form of the holding of reserves and U.S. Treasury bills (T-bills) by the creditor countries.

The United States has played the role of the banker to the world, drawing in surpluses from Asia and the oil exporting countries, and recycling these in the form of private capital flows to emerging markets in the periphery. The countercyclical pattern of the private flows to emerging markets, noted above, was critical to the mechanism by which the dollar’s role was preserved. These private capital flows served as a safety-valve mechanism, enabling the export of crisis to the debtor-periphery. While the United States has not been immune to episodes of financial fragility in this period — such as the 1987 stock market crash, the savings and loan crisis of the late 1980s and early ’90s, the collapse of Long-Term Capital Management in 1998, or the dot-com bust at the turn of the century — the corresponding financial crises were far greater in the periphery. By 2007 however, this mechanism had begun to lose some traction.

This Time it Is Different

By 2007 the United States absorbed 65 percent of global capital imports compared to 34 percent in 1995, a culmination of more than a decade of worsening global imbalances. This was accompanied by a growing stockpiling of foreign reserves by emerging markets. The emerging economies turned from being current account deficit countries through the ’80s and ’90s to acquiring increasing surpluses since 2002. By 2006 developing countries were financing more than 70 percent of U.S. current account deficits (see chart 3). At the same time, after the experience of the Asian crisis, emerging markets perceived the need to increase precautionary holdings of foreign reserves in order to insulate their economies from the impact of capital flight. Reserve holdings by developing countries rose to about $2.7 trillion in 2006 of which about 60 percent are held as dollars. Thus the periphery was not vulnerable to capital flight and foreign exchange fluctuations in the same way as it had been in the previous decades.

Chart 3: Current account balances of the United States and developing countries (billions of dollars)

Source: U.S. Bureau of Economic Analysis, Global Development Finance.

Another difference is that the countercyclical pattern of flows that characterized the period from 1973 is no longer in evidence after 2002 (see chart 2). After the collapse of the dot-com boom in 2002, instead of launching a new credit bubble in the emerging markets, the policies followed by Alan Greenspan helped stoke a bubble in the U.S. housing market. Buyers across the globe began investing in U.S. mortgage-backed assets, and over a trillion dollars of funds from around the globe were swallowed up by the U.S. subprime markets. This helped finance the purchase of homes all over the country, and enabled the growth of debt financed consumption. The financial bubble in the United States led to the emergence of a new pattern of dollar recycling that channeled capital flows from the surplus countries in the periphery towards U.S. markets.4 The exploding of the bubble with the collapse of the subprime mortgage market was associated with a reversal of the recycling mechanisms that exported fragility to the periphery through the ’80s and ’90s. The unraveling of the shadow banking system in 2007 was followed by a panic pull-out of foreign private capital from U.S. assets. This further exacerbated the crisis. Private capital inflows to the United States dropped significantly in 2007. This is when the dollar went into a sharp decline, which was, however, soon reversed.

In the initial stages of the subprime crisis the impact was largely contained within the North Atlantic capitalist core of the United States and Europe (particularly the United Kingdom). Emerging markets were relatively less exposed to the market for mortgage-backed securities. Capital flows to emerging markets continued to rise and flows to developing countries surged in 2007 by about 40 percent from its 2006 level. Commodity exporters, in particular, were thriving on the basis of the boom in prices as investors went scrambling for returns to the commodity futures markets.5

A Safe Haven in a Global Crisis

However the events in the first two weeks of September — the rescue of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the fire sale of Merrill Lynch, and the rescue of AIG — heralded the complete freezing of credit markets. Financial institutions hoarded cash and demanded ever widening premiums before lending to one another. The contagion effects of the credit crisis in the United States now spread globally, leading to capital flight from Eastern Europe, Latin America, and Asia. At a time of world crisis when markets do not have any confidence in the ability of debtors to honor their debts, and have frozen lending, T-bills—in other words international money—became the safest bet.

The dollar began to rise against a host of currencies (excluding the yen) as U.S. investors repatriated funds, speculators turned increasingly averse to risk amid the growing turmoil, and market operators sought dollars to meet their lenders’ demands. Investors and banks also began to withdraw their money from investment banks and hedge funds. The result was the fire sale of assets; “deleveraging” created a sudden desperate need for cash in the form of dollars.

Even as the credit machinery remained jammed and the U.S. Treasury and the Federal Reserve (hereafter referred to as the Fed) were floundering through the different incarnations of the Troubled Assets Relief Plan, the global demand for T-bills grew. Though the Fed had cut short-term interest rates, the intense demand for Treasuries from financial institutions pushed the yield even lower, briefly below zero on December 8, 2008. Panicked institutional investors were more than willing to lose a little for fear of losing a lot, and dollars in the form of T-bills seemed the safest port in the storm.

Marx had argued that capitalism’s propensity to financial crisis arises “where the ever-lengthening chain of payments, and an artificial system of settling them, has been fully developed.”6 The growth of finance which developed as a powerful force shaping dollar hegemony over the past three decades has bred such an artificial chain of payments internationally.7 In Marx’s analysis a credit crisis manifests the breakdown of “the chain of payments” that constitutes the financial system. This breakdown creates a frenzied clamor for “money” as the safest and most liquid, riskless asset. This collapse of the credit mechanism to its monetary roots — manifested in the resurgent demand for T-bills — is a classic sign of monetary crisis in the history of capitalism.8

The Crisis Hits the Periphery

Writing a year ago in Monthly Review, before the credit crunch had taken hold of the global financial system, I had suggested that the surge of capital flows to emerging markets through 2007 might create the conditions leading to a fresh wave of financial crises in the periphery and the revival of flows back into the United States. By the time the full force of the panic hit in September 2008 capital had begun flowing back to the United States, and outflows from emerging market bond and equity funds reached $29.5 billion between June and September 2008 (the highest level since at least 1995). The commodity bubble in developing countries also collapsed, as investors fled from all forms of risk, and export demand fell with the impact of recessionary forces in the United States, United Kingdom, and Europe. The accumulating surpluses and reserves in emerging markets began to erode. Stock markets crashed in Asia and Latin America as investors began pulling out and seeking the safety of the dollar.

Capital flight from the emerging markets has precipitated a fall in some emerging market currencies of as much as 50 percent, fueling currency crises in Iceland, Hungary, and Ukraine. Eastern Europe has been particularly vulnerable.9 With current account deficits approaching 7 percent of GDP and private capital inflows amounting to 11 percent of GDP in 2007 — a level that exceeds that of developing countries in Asia and Latin America — it is not surprising that a severe financial crisis erupted in Eastern Europe. But where the crises of 1982–83 and 1997–98 in Latin America and East Asia were effectively deployed to further U.S. hegemony, the current economic collapse of the “shock therapy” neocapitalist regimes in Eastern Europe is a challenge to U.S. imperialism, not an opportunity.

Although the emerging markets are besieged by capital flight and confront the contradictions of their export-led development strategies, the unraveling in the periphery has not, in the much more serious world crisis of today, resulted in a renewal of the financial system at the center. The inflows to the United States are largely in the markets for U.S. Treasuries rather than into the battered private financial system. The European Union is denied similar recourse since there is no comparable market for sovereign debt at the level of the European Union. As a result, paradoxically liquidity in the U.S. markets remains at all-time highs. The real problem is that despite all this liquidity the credit machinery has refused to restart as banks and financial institutions remain wary of lending, and are simply stockpiling excess reserves. In other words the supply of money is way up but its velocity is even further down, keeping deflationary forces strong. Consequently, the international financial system shows no signs of revival.

Signs of Strain

The Fed lies at the heart of the international financial system. It has to juggle the conflicting claims of maintaining U.S. imperial interests and domestic imperatives.10 The response of the Fed and the U.S. Treasury to the current crisis is shaped by these twin domestic and international imperatives.

The Fed normally regulates the volume of credit in the economy by calibrating the Federal Funds rate (the rate at which banks lend surplus funds to one another) to expand or contract credit flows. But the implosion of the financial system undermined the efficacy of traditional policy tools. While the Fed has reduced its target interest rates to near zero, there has been virtually no impact on kick-starting lending.

In these circumstances the strategy that the Fed has adopted to arrest the downward spiral of asset prices is to foment inflation by expanding the money supply.11 The Fed is injecting short-term liquidity into the financial system by buying T-bills (in exchange for newly created cash reserves) and holding them on the central bank’s balance sheet.12 This policy of inflating your way out of a crisis of falling asset prices is called “quantitative easing.” Moreover, the Fed’s policy under Bernanke is not restricted to the purchase of government securities but also involves “qualitative easing” or “credit easing” — taking onto its balance sheet a wide range of financial assets of lower quality than short-term Treasury obligations. One implication of this policy is that the Fed’s balance sheet is set to expand almost without limit. Its balance sheet rose from $874 billion in August 2007 to $900 billion before the fall of Lehman Brothers. Over the few months since, it has surged to about $2 trillion. During the last quarter of 2008 the share of Treasuries on the asset side of this ballooning balance sheet declined from 90 percent to 21 percent as the Fed acquired riskier assets, including mortgage-backed securities and commercial paper.13

One reason why this massive injection of funds is not translating into reflation is because financial institutions are hoarding money in the form of excess reserves kept at the Fed. From normal levels of around $7 billion, these reserves are currently pushing $1 trillion and are still rising. The problem is again that this credit crisis has resulted in a collapse of the paper edifice of the bloated financial system, forcing it back on its monetary base.14

By reassuring investors that it will hold overnight lending rates at near zero for the foreseeable future, the Fed has essentially given traders a cost-free way to borrow overnight and invest the proceeds in higher yielding assets. The implicit hope is that the increased borrowing will be used to purchase higher-risk financial assets and revive the securities markets and financial flows into the United States. In other words foster another bubble! The financial press is already warning of the possibilities of a Treasuries bubble.15

The danger is that this policy would propel a flight of currency from dollar markets. The announcement of the zero-interest-rate policy and quantitative easing halted the rapid rise of the dollar after four months in which the U.S. currency recorded its biggest gains since 2002.16 While the U.S. Treasury bill continues to remain a globally sought safe haven, that status is unlikely to remain unscathed. The market for Treasuries is likely to face a glut of T-bills in search of buyers, as the Fed balance sheet expands and so does the government’s need for finance. The increasing debt overhang may undermine confidence in U.S. Treasuries.

It is quite clear that the U.S. imperial agenda of refashioning the post-crisis world in a way that preserves dollar hegemony depends critically on China, which has finally outpaced Japan as the biggest holder of U.S. Treasuries. China has in a sense been locked into dollar holdings because selling off its mountain of Treasuries would precipitate a crash of the dollar and a collapse of its (dollar) asset base. This “balance of financial terror” underlay the arrangement where China stockpiled dollar reserves in order to pursue its strategy of export-led growth.17 Even though China cannot sell off its mountain, it may not be able to continue to add to its pile at the same rate either. The slowdown in Chinese exports, which began to decline sharply in the last quarter of 2008, would mean a flagging demand for U.S. Treasuries at precisely the point when issuance is skyrocketing.

The twin challenges for the U.S. imperial agenda are the restortion of the domestic economy and the refashioning of the battered global financial architecture to preserve the hegemony of the dollar. Despite all the talk of the renewal of financial regulation, Main Street prevailing over Wall Street, the reality is quite different. The slew of policies the Fed is adopting, and the ones that it has not adopted, suggest that they want a recovery of the domestic economy without constraining finance. This was quite apparent in the very distinct trajectories of the fiscal stimulus and the Wall Street rescue packages through Congress. However, internationally, the global recessionary forces that have been let loose with the credit crisis have also sparked a greater clamor for protection of domestic labor and industry, and for greater regulation and supervision of international capital flows. If this is sustained by a return to economically progressive agendas across the globe, and the strengthening of “South-South” mutual support networks — independent of the control of the United States — it would erode the dominance of finance, and would further weaken the privileged position of the United States at the heart of the international financial system.

Notes

1. See W. Munchau, “The Dollars Last Lap as the Only Anchor Currency,” Financial Times, November 27, 2007. Go back
2. In 1998, what Business Week termed “the SWAT team” of U.S. Treasury officials—Lawrence Summers, Timothy Geithner, and David Lipton—used the opportunity of the Asian credit crisis to dictate conditions to the South Korean government that forced the opening their financial system. “The Asian Swat Team from Washington,” Business Week, February 23, 1998. As a result the Korean stock market became a gambling casino for foreign investors. Go back
3. Ramaa Vasudevan, “Dollar Hegemony, Financialization, and Imperialism,” Monthly Review 59, no. 11 (April, 2008). Go back
4. Kenneth Rogoff and Carmen Reinhart, “Is The US Sub-Prime Market Crisis So Different?” American Economic Review 98, no. 2 (2008), 339-44. Go back
5. The speculative actions of arbitragers, manipulators, hedgers, speculators, and index investors promoted the commodity bubble at a time when speculators were seeking profitable investments as the market for collateralized debt obligations crashed. Randall Wray, “The Commodity Bubble: Money Manager Capitalism and The Financialization of Commodities,” Public Policy Brief 96 (Levy Economic Institute, Bard College, 2008). Go back
6. Karl Marx, Capital, vol. 1 (New York: Vintage Books, 1977), 235. Go back
7. Leo Panitch and Sam Gindin, “Finance and the American Empire,” The Socialist Register 2005 (New York: Monthly Review Press, 2005), discuss the integral role of the process of disciplining labor to the rising dominance of finance. More recently they argue that the scale of the current crisis cannot be understood apart from how the defeat of U.S. trade unionism played out by the first years of the twenty-first century. See “The Current Crisis: A Socialist Perspective” The Bullet (September 30, 2008). Go back
8. Marx has a remarkably prescient analysis of monetary crisis: “Whenever there is a general and extensive disturbance of this mechanism, no matter what its cause, money becomes suddenly and immediately transformed, from its merely ideal shape of money of account, into hard cash....On the eve of the crisis, the bourgeois, with the self-sufficiency that springs from intoxicating prosperity, declares money to be a vain imagination. Commodities alone are money. But now the cry is everywhere: money alone is a commodity!...Hence, in such events, the form under which money appears is of no importance. The money famine continues, whether payments have to be made in gold or in credit money such as bank-notes.” Karl Marx, Capital, vol. 1 (New York: Vintage Books, 1977), 235–36. This analysis foreshadows Keynes’s discussion of the liquidity trap where investor confidence has been severely battered and the preference for liquidity is absolute. Go back
9. International Monetary Fund, Global Financial Stability Report (Washington D.C., 2008). Go back
10. J. Lawrence Broz, The International Origins of the Federal Reserve System (Ithaca: Cornell University Press, 1997). Go back
11. This was the policy that Irving Fisher urged on FDR during the Great Depression. Jan Kregel, “Krugman on the Liquidity Trap: Why Inflation Won’t Bring Recovery in Japan,” Working Paper No. 298 (Levy Economics Institute, Bard College, 2000). It was also the basis of the decision to devalue the dollar by raising the price of gold. Bernanke, who cut his professional teeth studying the Great Depression, argued that “The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.” Ben S. Bernanke, “Deflation: Making Sure ‘It’ Doesn’t Happen Here” (remarks before the National Economists Club, Washington, D.C., November 21, 2002). Go back
12. FT Alphaville (Financial Times blog, http://ftalphaville.ft.com/) carried some of the earliest and most cogent chronicling of this strategy of quantitative easing. Go back
13. “Fed Assets Fall to 1.9 Trillion as Foreign Currency Swaps Drop,” Bloomberg.com, March 5, 2009. The Fed’s balance sheet appears likely to reach $3 trillion following their announcement of March 18, 2009. Go back
14. In other words, the monetarists have got the wrong end of the stick—money supply responds to the demand for money not vice versa. This argument, which goes back to Marx and Keynes, is integral to the analysis of the endogenous money school including post-Keynesian economists who see the financial system as one based on credit money. See L. Randall Wray, Understanding Money (Northampton, MA: Edward Elgar, 1998) and Makoto Itoh and Costas Lapavistas, The Political Economy of Money and Finance (New York: Palgrave Macmillan, 1999). Also see Steve Keen, “The roving cavaliers of credit,” Debtwatch, February 31, 2009, http://www.debtdeflation.com/. Go back
15. John Kemp, “Fed Unleashes Greatest Bubble of All,” Reuters, December 17, 2008. Go back
16. John Kemp “Fed Cut Sparks Dollar Dive,” Reuters, December 18, 2008. Go back
17. Luo Ping, a director general at the China Banking Regulatory Commission, while speaking at the Global Association of Risk Management’s 10th Annual Risk Management Convention, said: “‘Except for US Treasuries, what can you hold?’ he asked. ‘Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option.’ Mr Luo, whose English tends toward the colloquial, added: ‘We hate you guys. Once you start issuing $1 trillion–$2 trillion [$1,000bn–$2,000bn]...we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.’” Henny Sender, “China to Stick with US Bonds,” Financial Times, February 11, 2009.

Monthly Review - Abril 2009