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The Federal Reserve’s recent announcement that it would purchase up to $600 billion in US debt in order to unfreeze credit markets has raised the hackles of most of the industrialized world. The complaints from Germany, Japan, and especially China regarding the Fed’s second go-around of “quantitative easing” (aka “QE2″) threaten the greenback’s position as the number one reserve currency for the world, and raise the possibility of counter moves from other nations’ central banks to guard against inflation and asset bubbles.
The controversy threatens to make the G-20 conference in Seoul that began Wednesday an exercise in damage control, as most of the industrialized world is nervous about the US recovery and how the devalued dollar might affect its own balance of payments with the US.
If you’re like most of us and found Econ 101 a crashing bore, you can be forgiven for being unfamiliar with quantitative easing and what it’s supposed to do. A nice, simple explanation can be found here. Basically, by way of prestidigitation, the Federal Reserve conjures up a specific amount of money out of thin air — $600 million in this case — and then purchases government and corporate bonds, thus giving banks a boost to their own reserves and, theoretically, making it easier for them to make loans and generate economic activity. Sometimes it doesn’t work at all – especially in uncertain times. Banks are perfectly free to pocket the extra cash and apply it to their reserves, hedging against another downturn. Good for the banks, bad news for the economy.
Quantitative easing is a measure of last resort because the risks of spurring inflation and creating imbalances in some assets are elevated. Other nations with strong export economies like Germany, Japan, and especially China, are worried that the addition to the money supply in the US will further erode the value of the dollar, making US exports more attractive while increasing the price of their own products. This could lead to a trade war — something that will have to be addressed in Seoul. In short, the cure may end up being worse than the disease.
As other nations see it, the dollar is more than just the US’s currency, it is also the world’s reserve currency. This benefits the US economy because the greenback is constantly being propped up by the rest of the world, which doesn’t want to see the value of other currencies plummet. When the Fed takes drastic action, like creating money and pouring it into the financial system of the US, the resulting flood of cash makes central bankers nervous about inflation and governments worried about the export sectors of their own economies.
How long will the dollar be used as the world’s backstop currency? Not very long if China has anything to say about it. Zhou Xiaochuan, head of the People’s Bank of China, set off a wave of unease last year when he almost casually suggested that the world’s financial system could do better if it wasn’t using the dollar as a reserve currency. In a speech last Friday, Zhou revisited that theme:
We can understand the Fed’s QE2 policy, from the angle that it wants to revive the U.S. economy and increase employment. But the problem is the dollar is the global reserve currency…It may not be the right choice for the global economy, though it is a good option for the U.S. economy.
China is, itself, under the gun for its own currency manipulation, but this kind of challenge coming from a nation with an economy the size of China’s will bear watching in Seoul and the months ahead.
China’s jawboning is only the tip of the iceberg. Chancellor Angela Merkel’s Germany has been even more vociferous in opposition to Fed Chairman Ben Bernanke’s QE schemes.
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