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FACTDROP: The secret currency union


The secret currency union

Πηγή: Nikkei Asian Review
By Thomas Mayer
16 Oct 2015

What is the largest currency union of the world? The European Monetary Union, of course, you may think. Wrong. It is the U.S. dollar union. In an interesting paper, Robert McCauley and Tracy Chan of the Bank for International Settlement have shown that a large number of countries have more or less strongly pegged their currencies to the U.S. dollar ("Currency movements drive reserve composition", BIS Quarterly Review December 2014). 

According to their estimate, the U.S. dollar plays a key role for an area accounting for about 60 percent of global gross domestic product. Thus, the U.S. dollar zone is six times as large as the euro zone. As is customary in a currency union, many banks and companies in the U.S. dollar zone have assets and debt denominated in U.S. dollars. Like the European Central Bank in the euro zone the U.S. Federal Reserve determines financial conditions in the dollar zone.

As a result, developments have recently been similar in the two currency zones. When interest rates in other EMU countries fell to the low level of Germany at the beginning of the EMU, credit surged in these countries so that states and private entities became over-indebted. With the subsequent renewed rise in interest rates the credit bubble burst and pushed EMU into crisis. For members of the dollar zone interest rates plunged when the Federal Reserve fought the financial crisis triggered by the collapse of the subprime segment of the U.S. mortgage market. 

Like the countries of the euro zone before, the countries in the dollar zone then experienced a credit boom that also led to over-indebtedness. When the Fed ended its policy of quantitative easing and began musing about raising interest rates, the member countries of the dollar zone came under pressure.

The crisis in the dollar zone has not yet reached the intensity of the euro crisis. But the crisis there could broadly follow the script of the euro crisis. When states and banks in the euro zone were on the verge of financial collapse, stronger countries began to give financial assistance. But it was above all the ECB that stabilized the euro zone. The ECB assumed the role of lender of last resort to commercial banks and funded capital flight from the crisis countries through its interbank payment system (Target2). It also launched a program (dubbed outright monetary transactions or OMT) that turned it into a lender of last resort to troubled states.

In the dollar zone, similar capital movements from the periphery to the center have begun. Like in the euro zone this will create shortages in the refinancing of dollar denominated debt. In contrast to the ECB, however, the Fed has no mandate to support orderly payment flows in the dollar zone. But if the Fed stands on the sideline, a shortage of dollar funding could lead to the collapse of banks and companies in the periphery of the dollar zone. This could push the global economy into the next recession.

What could be done to prevent this? The International Monetary Fund and the World Bank warn against interest rate increases of the Fed. But zero rates and bloated central bank balance sheets can only push the problem into the future -- at the cost of magnifying it. Others want the Fed to provide dollar liquidity through swap agreements with other central banks of the dollar zone. 

But will the American public tolerate the accumulation of large claims of the Fed against shaky foreign central banks? This is unlikely. In the end, there will be only one solution: the unwinding of the dollar zone. This may well be painful, but a crisis can also pave the way to a new beginning. I do not know how this will look like. But two things seem likely to me: Central banks will be stripped of most of their power, and formal or informal currency unions will be out of favour.

Thomas Mayer is founding director of the Flossbach von Storch Research Institute in Cologne, Germany.

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