The Falling Dollar

An index of the value of the American dollar against has decreased by 15% in the past half year, from 89.11 on March 5th to 75.24 on October 20th. Because the American dollar has been described as a “safe haven” in the investment market for a long time, the simplest explanation of the currency’s decline is based on the increasing value of risky assets, lowering the demand for the dollar to hedge. But this hardly constitutes an outright collapse, nor is it necessarily cause for concern.

Worries about the dollar are hardly new. The current-account deficit of America has increased since the 1980s, implying the pressure on depreciation. Some may argue that the U.S. dollar’s dominance is due to America’s position as a superpower, which is, however, now seriously challenged by the emerging countries. Moreover, these emerging countries, like China and Russia, who hold a large portion of their reserves in dollars, have recently called for the need to shift the world’s currency reserves out of the greenback. All of these factors cause the weakness of the dollar.

The weakness of the dollar has also revived fears of a currency crash. However, this kind of concern is going too far. Depreciation, if it continues in the future, will be a gradual move instead of a sharp crash. That is because its liquidity ensures the dollar’s irreplaceable position as the settlement currency of international trading and the main currency reserve for most central banks. It is clear that no other currency can compete with the dollar in terms of the amount in circulation, maintaining demand for the greenback. In fact, the financial crisis actually caused a flight to dollars as a safe-haven, proving that the dollar is still considered a safe asset, and the recent weakness merely reverses the previous risk aversion.

Responses of countries with floating exchange rates to the dollar’s slide vary. To ease appreciation of the Brazilian real, Brazil’s government directly reintroduced a tax on foreign purchases of equities and bonds this week, causing the real to fall by 2% and Brazil’s stock market to drop by 3%. Instead of similar direct measures, the Canadian government has resorted to “talking their currency down,” saying that the strength of the Canadian dollar would offset the good news in the past three months. The foreign-exchange market responded to the statement immediately, leading Canada’s currency to fall by 2% against the American dollar. In general, since the recovery is uneven between different regions, countries with stronger trading relationships with Asia, such as Australia and Japan, are relatively sanguine about a weak greenback.

The lesson we have learned for the past year is that the dollar is that during the financial meltdown the dollar was still a currency to flee to, not from, showing that a dangerous collapse in the greenback is unlikely. But since the American budget deficit is expected to last for years and the world’s trading imbalance cannot not be solved in the short term, all governments may have to prepare to face a weak dollar for a long time.

Current Account Deficit: Magic or Disaster?

For those who believe China’s huge current account is the root cause the financial crisis, this is good news- their surplus is finally shrinking. In the first half of this year, the surplus narrowed to $130 billion, one-third lower than a year earlier, and barely half its level in the second half of 2008. The narrowing surplus can help China’s government to ease the pressure on the Yuan to appreciate, and also reduce imbalances in the world economy. China’s statistics, however, are notoriously tricky, and this is why some analysts still hold a skeptical attitude toward these figures.

Being one of the primary components of the balance of payments, the current account is the sum of the balance of trade, net factor income and net transfer payments, illustrating how capital flows across borders. When a country has a current account deficit, it means that people in this country spend more than they have earned, resulting in the decrease of the country's net foreign assets. Based on IMF data, the following map is the accumulated current account from 1980 to 2008, telling us a vivid story about how the capital has “traveled” around the world over the past two decades: The hard working Asian spend much less than they’ve earned, and saved the rest of it in the way of buying all kinds of financial products issued by the private or public sector, like American Treasury bonds, hedge funds, etc. With all this hot money flowing back to the U.S., Americans have been buying or investing in things they cannot really afford, leading to the ballooning asset prices.



If you have read the book “The Age of Turbulence: Adventures in a New World” by Greenspan published in 2007, you would be interested in his point of view on America’s current account deficit. In the book, he emphasized that mainly driven by the private sector, America’s deficit merely reflects the attraction of America’s investment environment, and therefore, it is not a problem. Securities and assets with high and stable yields are like magnets, attracting money from all over the world back to America’s investment market, pushing up the need for US dollars, and offsetting the pressure on the dollar to depreciate. This theory even has an academic name: "Pitchford Thesis." With the help of this financial magic, Americans experienced a prosperous decade in the 1990s: a high economics growth rate, low inflation rate and low unemployment rate. Some economists even called this the economic miracle of America. Now, we all know this magical story ended in tragedy, but if the world economic imbalance still lasts, then the financial crisis this time will not be the only thing we should worry about.

The narrowing current account surplus of China seems to imply the decrease of the world economic imbalance, if the statistics are reliable. But from past record, however, China’s government is not so trustworthy. Their national GDP, for example, is always very different to the sum of provincial GDPs, making the numbers lackcredibility. And the current account they reported this time is much smaller than those suggested by its trading partners’ data. Actually, if you add up all country’s trade with China, China’s surplus should be $295 billion, more than twice as much as the $130 billion surplus logged by China itself. It is no wonder that some conspiracy theorists conclude that Beijing is deliberately understating its embarrassingly large surplus.

It is almost certain that Beijing’s number is understated. But despite its inaccuracy, the crucial thing for the rest of the global economy is not the precise size of China’s surplus, but the fact that it is finally shrinking.

Education Reform

No one would doubt the importance of education. Deliberately transmitting society’s accumulated knowledge, skills and values from one generation to another, education shapes children’s characteristics and competitiveness, defining a country’s future. This explained the result of the poll conducted for the Economist, which shows that almost three quarters of Americans think that the problems facing education are at least as grave as health care. Indeed, there is an appetite for reform.

Ironically, the financial crisis offers a great opportunity for education reform. Thanks to the federal stimulus, Mr. Duncan, Barack Obama’s education secretary, find himself in an unprecedented position, holding a surplus of more than $10 billion, including $3.5 billion to turn around schools. With his $10 billion, he has said he wants to “fundamentally change the business the department of education is in.” This ambition should not be too surprising, because this statement simply echoed the Obama’s demand for change while running the campaign.

The education department has divided cash into several programs, including a $4.4 billion “Race to the Top.” This program reward states for reform in several areas. It will streamline the collection of pupil data, which can be used to improve teaching. Also, states should set internationally benchmarked standards and use teacher’s performance to determine training, pay, and promotion. Moreover, the fund will support efforts to help struggling schools.

In some respects, education reform is even more difficult than health care reform. In the latter case, the problem is clear, and the solution is there. The “only” difficulty is that Obama must persuade his people that this reform is leading the country in the right direction. The education issue, however, is more complicated since it involves so many problems including race, social structure, parent’s attitudes, etc. Actually, a higher budget can bring the school better facilities, talented teachers, and a lower teacher-student ratio, but it cannot solve school violence, the imbalance of resources between private and public, and a high drop-out rate. Despite the huge budget, change will just be formalistic without the support of parents and the whole education system.

Of course, things are always easier in a theory than in practice. That is why Rand Weingarten, leader of the American Federation of Teachers, said “implementation is where reforms die.” But Obama promises that this time, change will be different- more comprehensive and more enduring. People are now waiting to see whether he is just a dreamer or a dream practitioner.

The Post-American World

Soon after being industrialized in the closing years of the 19th century, the United States became the most powerful nation on earth since imperial Rome. Though its unprecedented dominance of global economics, politics, science, and culture is still remarkably unrivaled, it cannot efficiently prevent “the rising of the rest”. In fact, the distribution of the power is shifting, moving away from American dominance to Asia, the Middle East, South America and every corner in the World, and the speed of shifting will inevitably increase. Every other country is eager to embrace the coming of the new era, but the question is: “Are Americans ready for the change”?

Although there have always been some skeptics about China’s growth, China has still grown over 9 percent a year for almost 30 years, the fastest rate for a major economy in recorded history. Some scholars have argued that these numbers are fake, and that corruption is rampant, bad debts are huge, regional tensions are mounting, and all these problems will eventually lead to the collapse of both the regime and economy. These predictions have been argued for two decades - since I was still a little child. However, most of them didn’t come true. There is one thing for sure, despite serious internal problems, China and other emerging powers, including India, Russia, Brazil, etc, will play more and more important roles in all kinds of international issues.

It took the author a whole chapter to compare the present situation of the U.S. to Britain’s once unrivaled empire. This may be because of the many contemporary echoes of Britain’s dilemma. Some scholars have pointed out that given its geography, population and resources, it could reasonably be expected to have 3 to 4 percent of Global GDP, but the real number is approximately ten times more than that. After other Western Countries caught up the industrialization, these abnormal imbalances would abate, suggesting that the big empires were bound to decline. Therefore, maybe the wonder is not that Britain declined, but that its dominance lasted as long as it did. Britain managed to maintain its superpower for decades even after it lost its economic dominance. According to the author, the trick is Britain accommodated itself to the rise of America instead of insisting on contesting it.

The main advice given by the author to American is to build broad rule, not narrow interests. The U.S should create a structure of rules, practices, and values by which the world will be bound instead of pushing its own particular interest abroad. In the age of rising new powers, all these rising countries will be eager to gain power and respect, for sure, but within the framework of the current international system. By doing so, American can ensure that the rising of the rest will not turn into a vicious competition, destabilizing the world. Most important of all, American themselves must value and follow the systems they’ve build.

A new era needs a new strategy. Unilateralism led the U.S. to become the only unrivaled superpower in the world, however, with cost of a lack of legitimacy. In this new age, especially in the wake of America’s financial crisis, the lack of legitimacy is a crucial deficiency. If Americans still think manipulating every international issue as much as they can, as they did in the previous century, will help them maintain their omnipotence, than this is just nostalgia, not a strategy.

The Arab World

Whereas Western Europe has made a massive stride towards political and economic union, and Asia has been experiencing a remarkable economic rise, the Arabs are still suffering from all kinds of stagnation and war. Arab glory with their long and proud history has gone, and only dictatorship, violence and diplomatic stalemate with Israel are left.

The image of Arab countries is often linked to all kinds of sufferings. Ruled by authoritarian governments, people rarely have chance to strive for personal freedom. The governments are notorious for their records of suppressing human rights, and the over-powerful internal security forces menacing its own people. Despite their oil, two out of five people in the Arab world still live on less than $2 per day, struggling to survive slightly above the poverty line. And until the conflict with Israel is solved, the fear of war will not stop haunting Arabs.

In the absence of democracy, Arab states rely on the extraordinary degree of suppression in order to stay in power. However, can regimes that are failing their people so clearly hold sway over some 350 million people indefinitely? People have been asking this question for decades, but we still see hardly any sign of change. The speed of democratic progress depends on the Arabs themselves, but the image of democracy has been tainted by George Bush for invading Iraq.

Economic growth, in opinion of many political scholars, is a possible engine to drive democracy development. It will produce an educated and entrepreneurial middle class with a strong demand for controlling their own fate. And as the power of the middle class grows, even the most autocratic governments will be forced to give in. Indeed, according to the “Economist”, economic growth and decreasing fertility in many Arab states have lead to the better education of their people, and demands for a bigger say in economies.

China’s experience, however, is a counter example to the idea that economic growth would inevitably lead to democratic development. In fact, for most of the people, democracy itself is an ambiguous notion; whereas what people really care about is a prosperous, stable and free country that democracy promises to bring. So if a country, such as China, which has brought their people a wealthier life and a certain level of personal as well as political freedom, and with political suppression only targeting a few specific people, then why democracy? In this case, it is quite understandable that people might prefer the political stagnation to the chaos that change might bring, and therefore autocrats can cut the cord between economic growth and democracy. Authoritarian rule in Arab countries is so ingrained that democratic change would be a huge leap. Even if we can expect further economic improvement, the chances of democracy are still impossible to predict.

What Went Wrong with the Economics

In the wake of financial calamity, the reputation of economics as a discipline established over many decades has taken a beating. The notion that free markets would regulate themselves and lead to a prosperous society now seems to be far-fetched. Having established a large number of fancy and esoteric theories, economists still failed to foresee the financial crisis. People can't help but ask: what went wrong with economics?

Modern economics is often criticized for their unrealistic assumption that people are act in rational ways. Stemming from this assumption, the theory of the efficient market has dominated economics for decades. Based on this theory, a large amount of mathematic models were built. Wall Street ransacked the best universities for game theorists, physicists, and statisticians to evaluate different choices. Many new and fashionable economic funds were created, and all kinds of creative new instruments were available in the financial market. People put their money into these funds, though none of them really understood how they work. In fact, this was exactly why these financial economists looked ever more trustworthy.

Every theory comes with skepticism attached. Economists were hardly naïve believers in market efficiency. Concentrating on the irrational action, behavioral economics, a newly prominent field, has gained people's attention quickly and one of its leading proponents has won a Nobel Prize for “having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” With the help of this theory, people have begun to understand how human beings' irrationality gives limitation to market efficeincy.

There were caveats aplenty. People knew the notion of the efficient markets is imperfect and cannot be completely relied upon. And people have also been aware of ridiculous assumptions of valuing mortgage derivatives on the basis that house prices would always rise. Moreover, some have warned that the incentives may encourage the fund managers to take higher risks. However, putting profit before consceince, those “smart guys” in the Wall Street chose to ignore these glaring warnings. Being too fixated on chasing profit and too cavalier about asset bubbles, they putted aside delicacies and overlooked the impending danger.

No matter how closely resembles physics or other natural sciences, economics, without doubt, is a social science. In physics, lack of due caution may cause failure of an experiment; while in financial markets, it may result in bankruptcies, financial crises, global disasters and human suffering. It might be incomplete and deficient in many areas, but economics did not go wrong. It was people’s greed that twisted the economic rules and left the world in turmoil, and now it is time to pay the price .

A Reexamination of the Free Trade Zone

The integration of regional economies has become increasingly regarded as inevitable. Protests against globalization never stop. None of them, however, can slow down the speed with which free trade agreements are signed. Countries are eager to form economic alliances to increase their strength. Globalization gained ground so quickly that people did not have the opportunity to examine the idea of a free trade zone- until the financial crisis happened. Can the Euro area, the biggest free trade zone in the world, survive this financial tsunami intact?

The formation and growth of the European Union was remarkably smooth. With 27 member states, a population of almost 500 million and a unified currency, the EU has achieved a success which could hardly have been imagined just a few decades ago. They have fufilled their remit to maintain the purchasing power of the euro. In 2008, the EU’s GDP reached $18.394 trillion accounting for 30% of gross world product. No other trading entities can rival them in scope. It is generally believed that the EU has worked fairly well so far. Nevertheless, their determination to unify was not fully examined before this year.

The financial crisis, without a doubt, is the biggest test to date for the Euro zone. It has reawakened worries about the imblance that has built up inside the Eurozone. Germany’s huge current-account surplus, matched by big deficits elsewhere, shows that they are suffering losses by using the Euro. Hidden protectionism is emerging everywhere, weakening people’s belief in free trading. Moreover, facing the biggest deficit in history, weaker countries in the Euro area are more likely to default than before, since the single currency removes the option of unilateral inflation.

It seems that the EU has survived well in the crisis so far. But it is just the beginning of the test. A sudden disaster may help people to unite even more closely. But the real test will come with the long-term fallout from huge deficits, economic stagnation and imbalance among countries. In the prosperous periods, people are willing to share benefit with each other. When the world faces an economic decline, can every country show the same level of willingness to partly sacrifice themselves for the benefit of the whole Union?

The world is paying close attention to what the EU’s next step will be. Will the crisis spur economic reform? Will the need for larger markets attract more countries to join? Or, conversely, will some of them start thinking about leaving? These questions all remain open.

SDRs

Having been the world's most wildly held reserve currency for decades, the US dollar's dominance in the international monetary system is now being questioned. Zhou Xiaochaun, the governor of the People's Bank of China, argued that the dollar-dominant system caused the exacerbation of global economic imbalance, and it is time to end America's financially privileged status.

Under Mr. Zhou's plan, the amount of “Special Drawing Rights” (SDRs) should be hugely increased. Also, he suggested that the IMF should form an SDR-denominated fund, and that dollar reserves should be freely transferrable to the SDRs. By doing so, SDR assets can be used as foreign exchange reserves, and governments can reduce their risk of dollar exposure.

SDRs are potential claims on the freely usable currencies of IMF members. The SDR, in fact, is not a currency, but rather an IMF unit of account, or fictitious paper assets. For example, when the German government needs Japanese Yen, they could exchange their SDR holdings for it. This transaction would increase the amount of the SDR in the Japanese current account, while decreasing it in Germany's.

Created in 1996, the SDR system aimed to cope with the US dollar crisis brought by the Bretton Wood international monetary system. Before Bretton Wood, the gold played a key role in international monetary transactions. At that time, each currency was backed by a strict gold standard. The quantity of gold worldwide is relatively fixed; while the economies of all participating IMF members as an aggregate are growing. This created an eventual lack of international liquidity. Seeking a way out of this difficult position, the Bretton Wood system was established in 1944 and the era of dollar came. To bolster faith in the dollar, the U.S. agreed to link the dollar to gold at the fixed rate of $35 per ounce of gold. By adapting the US dollor as the international currency, countries avoid liquidity problems and also eliminate the logistical and security problems of shipping gold back and forth across borders to settle national accounts.

There was a fatal, and even ridiculous, paradox called the Triffin dilemma for this system. In this system, the U.S. had to maintain current account surplus to maintain confidence in US dollars. At the same time, U.S. also had to maintain current account deficit in order to meet the need for international liquidity. This dilemma soon caused a disaster in 1969. America's huge current account deficit led to the US government having difficulty in exchanging dollars for gold. Loss of faith in the dollar pushed IMF members to look for an alternative. SDRs were born.

After U.S. unilaterally refused to fulfill their commitment to exchange the dollars into gold in 1973, the Bretton Woods monetary system eventually broke down. However, until today, the U.S. dollar still accounts for 65% of world’s foreign exchange reserves, while the SDR only accounts for less than 1%. In an essay written in March of this year, Mr. Zhou claimed this is the root cause of the current economic disorder, and proposed strengthening existing global currency controls, through the IMF, as a solution. This would involve a gradual move away from the US dollar as a reserve currency, and towards the use of SDRs as a gobal currency reserve.

In fact, the SDR is unlikely to become a reserve currency in the foreseeable future. It would take years to develop SDR money market that is liquid enough to be a reserve asset. Also, the SDR is only backed by agreement, rather than actual assets. Moreover, IMF requires 85% support of their members to strengthen the power of the SDR, and America, with nearly 17% of the votes in the IMF and benefiting most from the dollar-dominant system, will never approve it. In other words, when Uncle Sam says “no”, there is no need for further discussion.