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Yes, your question makes sense, and it is a good one.

In this scenario (if it makes any sense at all), there would not have been such a huge worldwide demand for dollars to repay debts, right?

The answer is no, not right. The demand for dollars would have been the same, and that also explains why the idea of currency baskets is problematic too. The reason is that there is nothing -- or not much anyway -- contractual, legal, or otherwise, that requires banks (or other investors or creditors) to keep the currency in their vaults in US dollars today.  They can keep US dollar currency, or they can make other loans or investments, or they can buy other currencies -- it's up to them for the most part, especially in the case of central banks which make decisions about reserve currencies.  So when someone repays a loan to them, creditors have the  option of putting the repayment in vault (or in a deposit with a central or other bank) in US dollars, or they can instantaneous buy a presumably safer foreign currency and put that in their vault instead.

What we observe, however, is that each and every day investors, creditors, and central bankers (including the Chinese who complain so much about it) all decide to hold significant US dollar reserves instead of the many other options available to them.  That is why we know that the political entitlement to wealth of holding a US Dollar is the safer castle wall during a crisis like the present than others forms of securing wealth.

by santiago on Wed Sep 2nd, 2009 at 01:47:21 PM EST
[ Parent ]
santiago: The answer is no, not right. The demand for dollars would have been the same, and that also explains why the idea of currency baskets is problematic too.

I'm probably banging up against my cognitive limits here, but here are two more ways I've been trying to understand this:

1.  Suppose we reduce the situation to an absurdly idealized simple situation, in which there are only two countries/currencies in the world, A and B, and their respective currencies happen to have a 1:1 exchange rate.  Now let's say there were a massive amount of debt denominated in A currency being held by B citizens and entities.  If those B borrowers had to repay that debt in A currency, then they probably would have to exchange large amounts of B currency for A currency, thus driving up the value of A currency with respect to B currency.  Is that correct, so far?

On the other hand, if those B borrowers were allowed to repay their debts in B currency, then the exchange rate would not be affected, or at least, not as drastically.  Is that correct?  Or am I missing some major factors?

If this scenario makes sense (a big if), then I don't see why the dollar would have gone up so suddenly against most major currencies if debt holders could pay back their debts in those currencies.

2. Another take I was wondering about:  What if Switzerland, not the U.S., were the source of all the mad financial shenanigans and most of the debt were denominated in Swiss francs and had to be paid back in Swiss francs (again, another fantasy, but...)  In this scenario, wouldn't we have seen a rush for Swiss francs and a corresponding rise in the value of the CHF?  If so, that would not be evidence for the relative pre-eminence of Swiss political authority in the world, would it?

Lastly, out of curiosity, I looked up the graphs for the last year's exchange rates of the US dollar against other major currencies, which with one exception of the yen, did show a steep rise of the US$ in the aftermath of the crisis.  Now, I believe the precipitous rise of the yen against all major currencies, including the US$, was due to a circumstance that was quite "prosaic", "technical", "artefactual", whatever you want to call it, related to the yen carry trade.  More to the point, the rise of the yen was not evidence of global investors' faith in Japanese political authority, but rather to the abnormally large extent of the yen carry trade.  If that is the case, then how can the rise of the dollar vs. other major currencies (other than the yen) be taken as evidence of faith in the political authority of the U.S.?

santiago: The reason is that there is nothing -- or not much anyway -- contractual, legal, or otherwise, that requires banks (or other investors or creditors) to keep the currency in their vaults in US dollars today.

But are they keeping their currency in US dollars today?  I doubt you can answer that by looking at exchange rates alone, but doesn't the steady decline of the dollar against all other major currencies in the graphs  below suggest that people are not in fact keeping their currency in dollars?

USD vs. Euro

USD vs. Swiss France

USD vs. UK Pound

USD vs. Chinese Renminbi

USD vs. Canadian Dollar

USD vs. Japanese Yen


The West won the world not by the superiority of its ideas or values or religion, but rather by its superiority in applying organized violence.

by marco on Thu Sep 3rd, 2009 at 05:39:47 AM EST
[ Parent ]
marco:

If those B borrowers had to repay that debt in A currency, then they probably would have to exchange large amounts of B currency for A currency, thus driving up the value of A currency with respect to B currency.  Is that correct, so far?

Correct, in the givens of your scenario.

marco:

On the other hand, if those B borrowers were allowed to repay their debts in B currency, then the exchange rate would not be affected, or at least, not as drastically.  Is that correct?

Yes, correct again. And I argue that this is effectively the case in the real world today because of highly liquid markets for currency and virtually costless and instantaneous exchange of currency. People therefore are in possession of a particular currency at any moment because they want it, not because they're required to.

The dollar did not go up in order to repay debts. That was my point.  It went up because people wanted to hold dollars relative to either other currencies or other assets.  However, we know that people were actually selling other assets -- real estate and stocks -- so that means that the dollar must have increased because people, for some reason, wanted to hold cash in US dollars.

Let's go to Switzerland:

What if Switzerland, not the U.S., were the source of all the mad financial shenanigans and most of the debt were denominated in Swiss francs and had to be paid back in Swiss francs (again, another fantasy, but...)  In this scenario, wouldn't we have seen a rush for Swiss francs and a corresponding rise in the value of the CHF?

No, and the reason is because repaying debt is NOT what people do when a country goes into mad financial shenanigans such as occurred in the US (or in Sweden in the early 1990's, for a closer comparison to your Swiss example). What people do is sell assets to hold currency, paying some debt in the process only incidentally.  (No one is clamoring to repay debt right now and creditors have no way of making people accelerate repayment either, so the driving phenomenon is assets sales not debt repayment.) And if safer currencies then the precarious domestic one were available, people, including lenders, will buy and hold those currencies.  In your Swiss example, people would sell Swiss real estate and other assets at fire sale prices and use the proceeds buy Euros or Dollars.  If they could, they would even borrow MORE CHF denominated debt to buy euros or dollars.

The question then, is why didn't that happen when US financial system collapsed last year and why isn't it happening now?  Your graphs tell a story of a surge in the dollar's value followed by a return to pre-crisis prices.  That's not a declining dollar story -- that's a stable currency story. The dollar's fall since the beginning of the year indicates a willingness to invest in productive assets, possibly including foreign assets, instead of holding cash, and that's good news, not bad.

So, if the dollar were perceived to be a weak security for wealth compared to other currencies, we should never have seen any surge in its price at all. Foreigners were not ones selling foreign assets to repay US creditors last year, which is your Swiss story. Foreigners were the net creditors, in fact, as shown by the US current account deficit. Rather, both foreigners and Americans were selling US assets (causing creditors to collect some it).  And they all tended to choose to hold dollars in cash while this was going on instead of immediately converting it to foreign currency or foreign assets. That's evidence that political power trumps everything else when it comes to money.

The Yen?  Following my narrative, Japan is the world's second largest economy, Tokyo is the financial center of Asia, and Japan is therefore the only nation-state comparable in power to the US in a crisis. People believe that the Japanese have the power to make good on their claims and debts, through coercion if not through growth. If people wanted to take some wealth out of Europe and America and go to Asia for protection, Japanese political authority to protect that wealth was the best bet.

by santiago on Thu Sep 3rd, 2009 at 12:31:25 PM EST
[ Parent ]
Thank you very much for answering all these questions so patiently and thoroughly.  This has been a significant help to me.

The West won the world not by the superiority of its ideas or values or religion, but rather by its superiority in applying organized violence.
by marco on Thu Sep 3rd, 2009 at 07:06:05 PM EST
[ Parent ]
Thank you as well for such stimulating and challenging questions.
by santiago on Thu Sep 3rd, 2009 at 10:38:17 PM EST
[ Parent ]
Thanks to both of you for a valuable increase in my understanding of currencies.

Btw, the swedish krona was in the swedish crises mentioned forced from a fixed rate and then dropped substantially vs european and american currencies. In accordance with the explanation.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Fri Sep 4th, 2009 at 07:04:30 AM EST
[ Parent ]
santiago:
The dollar did not go up in order to repay debts. That was my point.  It went up because people wanted to hold dollars relative to either other currencies or other assets.

Firstly, wherever there was an interbank market in dollar loans which froze up - and Norway was a good example - the result of the refusal by banks to roll over these loans was a requirement for dollars to settle the loans.

Hence the need for massive Fed currency swaps - mischaracterised as Fed "bailouts" eg of the poor, mismanaged, economic basket case that is Norway.

One of the key results of this, as far as I could see, was that the dollar appreciated against the relevant currencies.

Secondly, if a US owner of a leveraged foreign asset perceives that the value of the dollar is likely to fall relative to the currency of the asset location, then he is likely to get out of that exposure while the going is good.

I don't so much see that as a flight to safety, rather than as an aversion to foreign exchange risk.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Sep 5th, 2009 at 05:06:33 PM EST
[ Parent ]

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