In last week’s post, I gave a primer on the mechanism by which commercial banks “create money” by advancing loans. This was in preparation for this post, in which I will explain why a drop in the foreign demand to hold USD-denominated assets won’t by itself boost the value of the dollar. Although it is repetitive, let me remind readers of the context: I was recently in a debate on ZeroHedge arguing that the US dollar would forfeit its world reserve currency status sooner than most analysts think. One of the strongest points (rhetorically speaking) by the other side was that the Eurodollar market would solidify the USD, such that any shock to the system would, paradoxically, cause the dollar to strengthen against the euro, yen, pound, and other major currencies.
Since this was such an important part of the argument, I had Brent Johnson—of “dollar milkshake” fame—come on the Human Action podcast to flesh out our dispute. We covered the ground where we both agreed, and honed in our actual disagreement: Brent was arguing that the fractional-reserve, debt-based Eurodollar system meant that the quantity of dollars had to keep expanding, or else the whole thing would become unsustainable. Certain European individuals or firms who owed other Europeans USD-denominated debts would find it harder to obtain dollars during the crunch, which would spark a wave of defaults. But this would cause the quantity of Eurodollars—which are accounting creations of the private banking system, not of State-issued fiat currency—to itself begin contracting. Ultimately, the restriction in USD supply and the scramble for liquidity in a crisis would send the dollar skyrocketing against other currencies.
For my part, I have no doubt that we might see a European crisis with just those features in the next few years. My more modest point was that nothing will arrest the medium- and long-run decline of the dollar’s global importance, because the slippage of the USD itself will only cause it to weaken against other currencies. In particular, if the reason the global quantity of Eurodollars shrinks, is that foreigners want to reduce their holdings of USD-denominated assets, then in that scenario it becomes easier to service your USD debts. Far from leading to defaults, borrowers in USD would pay back with greater likelihood. So the Europeans could gradually unwind their exposure to the USD if they wanted; nothing in the system would push them back toward dollar hegemony.
Now that I’ve reviewed the context, and after having given last week’s refresher in the mechanism by which US banks “create” more US dollars domestically when they advance new loans, let’s apply the same framework to a European setting to see what happens if the demand to hold dollar assets suddenly drops.
To assess the impact of a sudden reduction in foreigners’ willingness to hold USD-denominated assets, let’s do a “before and after” analysis. So in this section, we’ll describe a scenario involving foreigners having a liability and assets denominated in, what is to them, a foreign currency in which their own central bank can’t create more base money. As is typical for an economist, I am going to make this story simplistic and contrived in its details, but I think we need to be bare-bones at this point to capture the essentials of the forces we want to investigate. Obviously, the reader can add more realism to the story, but so long as it doesn’t change my conclusion, I think this simplicity is helpful.
So: Suppose a branch of Deutsche Bank located in Germany has $1 million in actual US paper currency sitting in its vaults. One of its major customers is a manufacturing firm that exports to the United States. Because its revenue is ultimately priced in USD, this firm wants to conduct its operations in USD. So it borrows $10 million from Deutsche Bank, promising to pay back $11 million in one year. It uses the borrowed funds to buy materials, equipment, etc. from other European suppliers, who are all also willing to accept USD in these transactions.
The system remains a “closed loop” in this initial stage, because (by assumption) the other European suppliers are willing to hold checking balances denominated in USD with a German bank. (To keep things simple, let’s assume everybody involved all has a checking account with Deutsche Bank, even though that doesn’t affect the punchline.) So at the end of the initial transactions, Deutsche Bank still has $1 million in green pictures of dead American presidents in its vaults, and a total of $10 million in checking account balances held by various German firms. The original manufacturing firm also owes Deutsche Bank $11 million USD payable in one year.
Assume the manufacturer has forecasted properly, and is able to take its inputs and sell $11 million USD worth of exports into the American market. (For simplicity, imagine American importers literally sent over $100 bills to get their imports from the German firm.) The manufacturer pays back its loan (with interest) to Deutsche Bank. The bank has now seen its Assets transform from an IOU with a market value (the moment before redemption) of $11 million USD, into an actual $11 million in USD sitting in its vaults, along with the original $1 million.
Deutsche Bank doesn’t want to sit on that much cash, and let’s suppose the additional $10 million in US-denominated checking account balances is the most the German market is willing to absorb per year, and so DB takes the new cash and uses it to buy $11 million worth of Treasuries.
Thus, at the end of this typical cycle, Deutsche Bank ends up with $1 million in physical US currency in its vaults, and has added $11 million in US Treasuries to its holdings, while German companies have added $10 million in USD-denominated checking account balances to their holdings. (Note that all of these transactions would constitute a portion of the real-world trade deficit that the US currently runs with Germany.)
Now what would happen to the above story, if we supposed that German institutions in general didn’t want to increase their net holdings of USD-denominated checking accounts and government bonds? Would that cause some type of economic calamity? Would it paradoxically make the USD strengthen against the euro—at least in the short term—as Brent Johnson and others argue?
I imagine someone like Brent would be tempted to say, “Yes, of course there would be a squeeze! If the German institutions tried to switch out of USD and into more euros, that would initially start to make the USD fall against the euro. But then it would be harder for the German manufacturer to export into the US, and come up with the $11 million USD in order to pay back the loan to Deutsche Bank. So that’s what we mean, the foreigners on the hook for USD debts provide a source of demand for the currency.”
But in the particular story above, that’s not how it would play out. By assumption, the German manufacturer is conducting its accounting in USD, precisely to avoid currency risk. It won’t be harder to sell “$11 million worth” of products into the US market, just because the euro rises. Remember that this manufacturer borrowed in USD because it planned to get revenue in USD. So moves in the currency market won’t affect this borrower’s ability to obtain $11 million in USD and pay back its loan to Deutsche Bank. (If it had borrowed in euros that would be a different story, but then that wouldn’t be a USD-denominated debt, which is the focus of this debate.)
Now it’s true, at the start of the next cycle, if Germans don’t want to expand their USD assets, then the above story can’t simply repeat. When the German manufacturer tries to buy $10 million worth of inputs, the German suppliers won’t accept the deal and simply expand their USD balances with Deutsche Bank, as happened in the original story. But that doesn’t lead to a default on a loan payback; it just means the German manufacturer has to scale back its plans. (If it had borrowed the $10 million in USD from Deutsche Bank already, it can just pay it back early, without having spent it, or do some financial equivalent such as buy US corporate bonds to match its liability.)
And this is exactly what should happen, from a macro perspective: If the euro strengthens against the USD, then (other things equal) that should lead to a shrinking of the US/German trade deficit, meaning that German exporters to the US should see their sales drop. So to repeat, this particular German exporter might experience a “bad year,” but it won’t find it harder to export already-produced goods to America. There’s nothing in the drop in German demand for USD assets that would make it harder for a German borrower to pay back a loan denominated in USD.
If we look at things from the perspective of the other German suppliers who (in the previous cycle) had expanded their USD checking account balances with Deutsche Bank, they can simply withdraw their balances and switch them into (say) euros. On its end, Deutsche Bank would simply take its holdings of US Treasuries and sell them (perhaps through multiple steps) for euro-denominated bonds, in order to “back up” the checking accounts now denominated in euros. Sure, there could be issues of timing and friction, but in general, so long as Deutsche Bank had been trying to match assets and liabilities in both currency and maturity, this wouldn’t pose a systemic problem.
I deliberately worked with an example involving a German debtor that exports to the US, since that is the most “obvious” case where an initial fall in the euro might seem to pose a problem for loan payback. But even here, I hope I’ve shown that at no point in the above story, would anybody in this tale find it harder to obtain USD in order to pay back loans.
If analysts such as Brent Johnson or other (medium-term) dollar bulls want to push back with a different scenario, I would be happy to take a look, but I think we will always find the same pattern: When the community no longer wants to hold the item that you in turn owe to somebody else, it becomes easier for you to obtain it and make your loan payment.
NOTE: This article was released 24 hours earlier on the Infinite Banking (IB) 3.0 - The Future of Finance Group
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.
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