Three Important Historic Sources of Demand for US Dollars

Liquidity and The Triffin Dilemma
An illuminating historical discussion of liquidity needs is provided by Robert Triffin (1960). Briefly, after World War 2 and the Bretton Woods agreement, the world actually suffered from a shortage of dollars for the purposes of transactions. Since the dollar became the reserve currency for the world, countries needed to hold a certain amount of dollars throughout the year simply to conduct transactions with other countries. Particularly for countries with seasonal industries, large fluctuations in dollar holdings created a shortage of dollars; this resulted in a substantial demand for US dollars simply for liquidity purposes. Immediately after World War 2, the US ran a current account surplus, so a problem of that day (contemporaneously known as The Dollar Gap) was that foreign countries, particularly European countries, were chronically short of the dollars they needed for transaction purposes. In the late 1950s, as the US started to run a trade deficit, the dollar shortage was relieved. The fact that the dollar gap and liquidity shortage was relieved only after the US started to run a trade deficit was not a coincidence. A flow of excess goods and services in one direction must be offset by a financial flow in the other direction. Therefore, as the US began to consume more than they produced, the foreign world (in aggregate) began to accumulate more dollars than they spent.
The seriousness of dollar liquidity needs from the foreign world was reflected by one of two worries that Triffin had in 1960: namely, that if the US returned to a trade surplus it would choke off liquidity and growth for the rest of the world, and set off a Great Depression type of deflationary spiral. Triffin’s other worry – that the US would continue to increase its current account deficit until it became necessary to default on the gold agreement – was the one that actually came to pass.
This global demand for liquidity purposes mirrors the transaction portion of domestic demand for money, and both grow in proportion to the economy. So as the world economy grew and the size of transactions grew in dollar terms, the foreign demand for US dollars specifically intended for liquidity purposes necessarily grew. Since the world economy has grown by approximately twenty times, in nominal terms, since 1970, the liquidity demand for dollars has grown by a proportional amount.
Security: The Safety Trade
The so-called “safety trade” into dollars that occurred in the second half of 2008, while ironic in two ways, is not surprising. That the dollar represents security to foreign entities is partly due to historical good behavior and partly due to wishful thinking on the part of foreign entities . Certainly through 1960, the US had a virtually unblemished record in paying its debts and honoring its obligations. This historical precedent combined with geopolitical considerations and force of habit has created the foreign perception that exists to this day that the US dollar is “as good as gold.” Thus, historically, we observe that when a country suffered from a balance of payment crisis, the most common alternative to the home currency was the dollar. The list of countries whose private citizens hoard dollars as an alternative to the home currency is long: virtually any Latin American country, Russia, Eastern Europe, south-east Asia, etc.
The reason for this hoarding is fairly easy to understand. If a country pegs its currency to the dollar and the peg is kept too high, citizens of the country will consume more than they produce and the country will run a current account deficit. Mirroring this current account deficit, a country will run a financial account surplus which decreases its supply of dollars. As the supply of dollars approaches a critical point, citizens will speculate that the peg cannot be maintained and will “make a run” on the currency, trading all of their domestic currency for dollars in anticipation of the devaluation. This is referred to as a balance of payments crisis, and results in a devaluation of the national currency. Examples of recent balance of payment crises include the Argentine economic crisis (2001-2002) and the Asian financial crisis (1997). Citizens in countries who have suffered balance of payment crises will often hold a portion or even a majority of their wealth in dollars in anticipation of another currency devaluation.
As an additional demand, it is commonly considered good practice for a developing country to carry reserves in excess of what is necessary for transactions as a preventative measure against balance of payments crises. Thus, there is actually an incentive to peg a currency too low, as a method for accumulating a protective supply of dollars to prevent balance of payment crises.
Strategic Export Growth:
In addition to a proactive measure to prevent BOP crises, both developing and developed nations can create an artificially competitive export market by intentionally holding down the value of their currency. This artificially competitive export market increases production in the country, whose effects then multiply within the economy. In the short-run, or on a small scale, it is not clear that the effects of this are negative for the US. Although a depreciated foreign currency makes US domestic industries less competitive, a loss on the productive side is offset by an increased purchasing power of the dollar for consumption. However, as the effects persist and grow in magnitude it clearly creates imbalances (Figure 1) which almost certainly contain Pareto inefficiencies and deadweight loss.
This dynamic of strategic export growth is most easily seen in present day China. Examining China’s actions, we see a replay of a historical pattern that has worked well for economic growth in the world. Starting with Europe in the 1950s, Japan in the 1960s, Tiger Asia in the 1970s, and China, Southeast Asia and others in the 1980s, countries around the world have followed a similar blueprint for accelerated economic development. That blueprint consists of devaluing their currency to a level that makes goods produced in their economy attractive to foreigners. Then, as the balance of payment surplus grows, their central bank neutralizes the inflow of dollars by selling bonds into the market as it continues to buy dollars. By doing so, the quantity of Yuan in the economy remains the same. If the private market was left to assign value to the dollar, it would result in a depreciation of the dollar. By buying dollars, and neutralizing foreign exchange, their central bank is pegging the currency. In this circumstance, they also proxy for an investor with an extreme (100%) preference for US assets; this will become important to discussions later in the paper. The money that the export sector makes acts as a multiplier to the general economy in these countries, and this dynamic underlies the astronomical growth experienced by Europe in the 1950s, Japan (1960-1990), South Korea and the so-called Tiger countries (1970-2000), and China and South-East Asia (1980-2008).
Summary of Exchange Rate Dynamics
While all other countries have two primary mechanisms that determine their exchange rate, the US dollar has five. The two mechanisms present for all currencies are: the relative supply of the currency (determined by the central bank); and the terms and attractiveness to foreigners of domestically produced goods and services. All else equal, the greater the supply of currency the higher the exchange rate (depreciated), and the more attractive the terms of domestically produced goods the lower the exchange rate (appreciated). Both of these mechanisms are reflected in the current account: if a country devalues its currency through an increase in money supply, it will have higher interest payments on foreign denominated assets. In this circumstance, a net debtor will generally see a deterioration in the current account, and a net creditor will see an improvement. If a country increases the attractiveness of terms on its production to foreigners, it will improve the current account.
In addition to these two factors, the US also has the three exogenous mechanisms discussed above--liquidity, safety, and export growth. These exist primarily in the US, but are endogenous to any country holding the world reserve currency. These dynamics usually act to appreciate the dollar, which goes a long way toward explaining the peculiar ability of the US to run persistent current account deficits. However, if the mechanics reverse, then the mechanisms would likely act to depreciate the dollar. Thus, any expectations that transaction liquidity demand will decrease, that faith in the safety of the US dollar will decrease, or that the dynamics of export-driven growth strategy would reverse would serve to lower the expected value of the dollar. I now demonstrate why it is likely that all three of these dynamics will work in precisely this way in 2009.