The Investment Scientist

Is The Dollar The New Gold?

Posted on: August 2, 2019

“Why are so many countries lending to the US for negative real interest?” Professor Sussman opened the floor for debate at our Oxford macroeconomics class. In totality, foreign countries own $6.2T of US debt. The chart below shows the countries that lend to the US.

In the previous three articles, I wrote about The Gold StandardThe Fiat Money andThe National Saving Shortage respectively. I hope I explained that the trade deficit is recycling of foreign savings for US private investments. And as long as we are paying negative real interest on our national debt, It’s not a problem, but a win to be able to keep borrowing. What I did not explain is why foreign countries would lend to us at negative real interest, and this is exactly what the professor asked in class and what I hope to explain with this article.

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Here are at least three plausible explanations:

1. Competitive devaluation (or “currency manipulation”). This is an explanation favored by US administrations since at least Reagan. The explanation goes like this: Japan and later China, by keeping their trade surpluses in US treasuries, were able to keep the value of their respective currencies low, thereby increasing their industry competitiveness “unfairly.”

There is no macroeconomic theory that supports this explanation, however. On the contrary, there is a well-established macroeconomic theory called Money Neutrality that says the money supply makes no difference in a country’s competitiveness. For example: to make the Japanese Yen depreciate 10% in order to make Japanese goods 10% most competitive, Japan must increase its money supply by 10%. That, in turn, would lead to 10% inflation making Japanese goods costing 10% more to make. Japan would gain absolutely no competitive edge by debasing its currency.

Putting aside theory, why would any countries debase their currencies so that they can exchange more manufactured goods for fewer paper dollars in order to earn negative interest in US treasuries so that they can debase their currencies even more? The circular logic just doesn’t quite make sense.

2. The dollar is the New Gold. Developing countries like China and Brazil lack monetary credibility. They can’t print money at will so that they practice a new sort of gold standard. Except now, they use US treasuries (that is, US government debt) in place of gold. That’s why the dollar is also called the reserve currency since many countries hold US treasuries on their central bank balance sheet to support their local money issuance.

Essentially these countries are renting the monetary credibility of the US, and the negative interest rate is the way they pay rent to the US. This explanation however does not explain why Japan and western Europe are paying the same rent, since those countries have plenty of monetary credibility of their own.

3. The protection fee explanation. This one is controversial. Japan, wealthy gulf countries, wealthy Western European countries, and even China are paying the US for protection and for keeping the sea lanes open.

It is hard to argue against that Japan, gulf countries and western Europe need US protection. But China? Here is a little factoid that would explain it: 80% of China’s oil is shipped through the Strait of Malacca where the US has a navy base. Do you think China would be willing to pay 1% of negative real interest to the US on its $1.1T US debt holdings to keep the sea lane open? (That’s only $11b a year, a small price to pay.) Now this explanation, though plausible, is not an economical explanation but a geopolitical one.

Lastly, I’d like to show you a chart of the world’s major reserve currencies. The dollar is at 62%, followed by the euro at 20%, followed by the pound and the yen, both at 4% to 5%. This chart is basically telling us that the dollar is the new gold, the euro the new silver, the pound and the yen the new nickel. As long as the dollar remains the new gold, the US has the tremendous privilege of printing money and extracting rents from other countries with few repercussions. (Tell that to Argentina, Venezuela, and Zimbabwe.)

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My next article will discuss what would happen if the dollar lose the “new gold” status, that is, the status of the dominant reserve currency.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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