During the week I had an extended email conversation with an old friend. The interchange highlighted two aspects of the debate about the dollar’s ‘exorbitant privilege’, and the threat to that privilege. Namely, a) the debate is best seen as part of a declining faith in fiat currency generally, not just the dollar, and b) this tendency is vastly exacerbated by inflation. Inflation is ‘everywhere and always a social phenomenon’ – to steal a memorable adaptation from my friend. And recent policy has not improved matters.

Taken together, the inflationary episode of 2021-2023, and the damage done to the standing of Western officialdom, led by the US, both in allowing inflation, and the consequent fight against inflation, is part of wider expression of insecurity which permeate both domestic and global politics. It is an insecurity which promotes the siren appeal of authoritarians and undermines messy plurality. This corrosive trend is worsened because there is evident misunderstanding by the public of terms. Central bankers simply do not understand inflation in the same way as their publics; their mandates explicitly state they should not. Fiscal authorities simply don’t understand the Ricardian equivalence they promote among investors through increasing debts, nor the ‘crowding out’ effects official policy has endorsed. Not surprisingly, neither the public nor investors are so willing to accept earnest declarations by their fiscal and monetary officials that their welfare is paramount. Many would conclude their welfare is at best a secondary consideration in policy making. And there is no sign this is changing, which means trust in fiat continues to decline.

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Source: Photo by Joshua Hoehne on Unsplash

Our discussion was prompted by a recent interview by Erik Townsend of Luke Gromen. Luke, for those who don’t know, is sympathetic to the notion that the dollar dominance is threatened. In that interview, Luke points to the recent rise in gold and bitcoin as signs of investor concern about the debasement of the dollar. Well, maybe, maybe not. What is clear is the ‘all clear’ on inflation that central bankers are evidently desperate to announce does not accord with the sensitivities of the public or investors to fiat debasement.

Debasement is usually another word for inflation, and invariably involves the redistribution of real financial resources away from some members of the public and towards others – often, but not always, the government. A key aspect to Luke’s argument is that geopolitical differences will make US fiscal deficits increasingly hard to finance. In turn this will lead to permanently higher interest rates, increasing reliance on domestic investors, growing dissatisfaction with US power among developing countries reliant on dollar borrowing and, crucially, permanently higher rate of inflation. The US government needs to find a deep pool of reliable investors for future deficit financing. You don’t need to be an unreconstructed monetarist to link fiscal and monetary policy to recent high inflation. A large section of Western public has obviously made that link already. This suits the dollar foes in Beijing and Moscow.

Luke cited a letter from ISDA to US regulatory authorities as evidence of this tendency towards fiscal dominance. The letter requests a permanent exemption for Treasury bonds from Supplementary Leverage Ratio (SLR) and the risk-based surcharge for globally systemically important banks (GSIBs).

Anyone sensitive to signs of fiscal dominance won’t have to read far into the letter to be alerted. The first page of nine, justifies the exemption in the language of fiscal dominance. “It is important that banks have capacity to absorb a continued high volume of U.S. Treasury issuance, with the market projected to grow to exceed $35 trillion in the next five years… (from $26 trillion currently).”

The motivation for the letter is easily understood as part of a continuing negotiation between banks and regulatory authorities around regulation. The negotiation aims at crafting the final form of Basel Endgame and the plan by the SEC to introduce mandatory clearing of Treasury and repo operations. Banks claim both initiatives will add burdens. So naturally, they seek an offsetting proposal which authorities would probably look kindly upon.

However, the negotiation between ISDA (on behalf of the banks) and the regulators omits consideration of the public. And that is unfortunate. If banks and government agree to exemptions for Treasury bonds to accommodate more issuance on their balance sheets, then clearly the banks may have less room on their balance sheets for assets such as loans to the public. When Luke claims this seems to be QE via another route, we should ask if it will also displace loans on bank balance sheets and replace them with Treasuries. The ‘crowding-out’ effect of QE reallocates bank resources away from loans and into official sector assets, as the following chart using US commercial bank balance sheets shows. This was a key feature of QE.

If there is distrust about the outlook for fiscal policy, it is mostly focussed on the United States due to the centrality of the Treasury market in the global financial architecture. But the same fiscal dominance concerns afflict Europe, Japan, and probably Russia and China. All of which tends to increase distrust in fiat currency.

Still, concern outside the US focuses mainly on inflation, and the role central banks have in allowing inflation to rise so sharply.

Last week saw the 24th annual ECB Watchers conference. The conference could be summarised as an extended assertion that while central bankers acknowledge that recent inflation was a bad thing, they had learned their lessons, improved their procedures and it wouldn’t happen again. In effect, trust them. That is a tall order when no discernible change in approach has been made.

Bureaucracies don’t do contrition. And they find it difficult to modulate their contempt for the public they oversee. The point was inelegantly made by Philip Lane, the ECB’s chief economist at last week’s conference. In response to concerns that inflation may have distributional effects in society Lane asserted that those who had lost most in the bout of inflation were those holding the most cash in banks – i.e. the wealthy. This kind of response may be nominally accurate but is surely likely to elicit a derisive response from lower income groups. Especially against the background of impressive stock market gains.

The tin ear of such a comment is matched by the estrangement between what inflation means to the public and how it is seen by central bankers. Much of the ECB Watchers message was that the mandated 2% annual inflation target would be reached soon, though there are risks. Central bankers may think this represents ‘mission accomplished’ but the public certainly do not.

The public accede to annual 2% inflation because they don’t notice it. Once inflation becomes a conscious public concern then price level becomes the issue, not price change. Success in the fight against inflation for most of the public would mean a return price level to 2019 levels, not a slowing of the annual increase. This objection doesn’t appear while inflation remains low, but it is foolish for central bankers to believe they will be thanked for locking in higher levels of prices, which is what they appear to be asking.

Yet all Western central bankers behave as if moderation of price increase will assuage discontent with their performance. If that is not the case then trust in fiat currency everywhere will retreat. The threat to the dominance of the dollar is merely a particular example of the declining trust in fiat currency everywhere.

Of course, these developments suit those actively seeking to undermine the dollar’s influence. But the unifying characteristic of the dollar’s foes is their inability to propose any viable alternative. No one in their right mind would willingly accept renminbi as a reserve currency or as a means of trade invoicing – though it appears some poor souls will unwillingly accept it. The mixed messages from Western policy makers mean the mischief-making by China and Russia gets a more reasonable hearing than is warranted.

Recent purchases of gold by central banks globally are often portrayed as shift away from the dollar. Gold buying may signal diversification away from fiat. The same can be said of Bitcoin. It is entirely implausible that gold purchases portend a shift to some kind of new Gold Standard. The disruption such a move would unleash on China’s economic model would be catastrophic.

Since 1999 the compound annual growth rate of broad money in China has been over 14%, and as percentage of GDP China’s broad money is much higher than in any developed economy. China needs periodic credit injections to alleviate misallocation of capital. This is probably an integral part of the country’s political economy; true economic adjustment to misallocation is probably incompatible with political stability. Any attempt to link monetary growth to an inflexible standard would require either impossibly high Balance of Payments surpluses, and/or an economic depression. Neither seem a sensible choice for the CCP, though it can’t be entirely ruled out.

The most plausible threat to the dollar is a long-term undermining of trust, rather than the presentation of a plausible alternative. If the dollar’s foes can repeatedly point to its drawbacks, they can diminish the drawbacks of their own currencies even if they cannot point to a credible alternative.

Are there any plausible routes to reversing the decline in trust? Yes, of course there are. Solutions are almost comically obvious. Trust could be restored if policy makers treat their voting public as adults engaged in national resource allocation decisions and the public accepts the costs and benefits required of those decisions. A first step along that road would be a clear admission of the limits of knowledge by central bankers and central bank policy and the limits to government support. The fiscal direction of travel is entirely contrary to this prescription and central bankers just want criticism to go away. As neither fiscal nor monetary authorities appear to be serious about addressing the source of the decline in trust, the mischief-makers will continue to gain ground.

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