Could the US dollar collapse?

I’m something of a Ron Paul fan but sometimes he says something that really grates. In the car this morning I was listening to a Ron Paul podcast in which he said he feared the collapse of the US dollar. He went on to say that when currency collapse comes it generally comes very quickly. This grated  because it seems quite counter intuitive. The USA is one of the biggest economies in the world. In spite of recession they are still a power house with nearly 25% of all global production occuring within the USA. However I decided I’d give this question some more thought.

Firstly I should say that I’m not a recognised expert on monetary policy. I know enough to say that most economists have only a modest grasp on the issues. And beyond currency traders (and even including a lot of them) those in the finance sector generally only have a microeconomic understanding of money. As such I feel quite comfortable sticking my nose into this domain.   

So could the US dollar collapse? Firstly we need to decide what a collapse might mean. If collapse merely means losing 5% of value in a year relative to the EURO then collapse sometime during the next decade is probably inevitable. Of course the prospect of recovery from such a position is also probably also inevitable. If collapse means losing 99% of it’s value eventually anytime in the next 1000 years then obviously this is also probably inevitable. For the sake of a sensible definition we might assume collapse means losing 80% of it’s value within a 2 year period and a subsequent general inability to recover. And again for the sake of argument I’ll assume that the benchmark for value is the exchange rate relative to the EURO. We could choose Yen or gold or Pounds but simply for the sake of a conversation I’ll choose the EURO.

The value of a currency is determined by two factors and two factors alone. They are the demand for that currency and the supply of that currency. And supply and demand are merely flip sides of the same coin (excuse the pun) depending on your vantage point in a transaction. We can complicate things by looking at credit multipliers and the like but at the end of the day credit merely effects the value of currency by acting as a product substitute in some instances and so it may effectively dampen demand. In the final analysis it is just supply and demand that operate. Our modern fiat currencies are generally managed by central banks and the US dollar is no exception. Managing a currency generally means working to avoid collapse or a painful inflation or deflation.

So how does a central bank “defend” the value of a currency.  If a large number of people decide to dump your currency on the market the value will decline and ultimately the only thing a central bank can do in that situation is to let the value fall or to start buying back the currency. It may buy under the banner of increasing interest rates but this is merely symantics, the mechanics still entails buying through what they call open market operations. Of course it is possible that a central bank will simply allow the currency to fall but I won’t be so petty as to suppose that the central bankers might all leave on vacation on the same day. I’m assuming they don’t want the currency to collapse and will act according. I’m interested in knowing if things can occur that will take the avoidance of collapse out of their hands entirely.

How does a central bank buy currency? There is only one way a central bank, including the US central bank, can buy back it’s currency and that entails selling it’s assets in exchange for the currency. If it holds gold it might sell gold in exchange for US dollars. In so doing it provides demand for the dollar, or seen another way it reduces the supply of dollars in circulation. So it would seem that as long as it holds assets the central bank can keep on buying back currency and arrest even the most vicious dumping of the currency by other parties without any significant consequence for the value of the currency. In fact this is the case, so long as it holds enough assets.

So what are the assets of the US central bank? Well I had to dig a little but primarily they are securities (ie bonds). Primarily US government securities. Unlike our central bank they don’t appear to hold a lot of foreign currency or gold. The gold in Fort Knox belongs to treasury not the central bank. So mostly their assets are mostly piece of paper from the US treasury that say IOU so many dollars. And it has a lot of these. Slightly more in fact than it has US dollar notes in circulation (including the esoteric electronic version of notes it stores for commercial banks – don’t tie yourself in knots worrying about the distinction). So for the US dollar to collapse it would seem that the value of these assets would also need to collapse. This is where it gets interesting.

If I have an IOU that says “Fred owes Terje three goats” then the value of that IOU is determined by two things. One is the value of goats. The other is the financial credibility of Fred. Perhaps you can see where this is leading but let me spell it out a little using the terms in this example.

We have these things called goats that have value. If people dump goats on the market we can defend their value by buying up lots of goats. To buy the goats we sell these assets called “IOU goats”. However if the value of goats is declining so is the value of “IOU goats”, and in fact they are losing value in direct proportion. This may seem odd but in spite of this circular relationship we must admit that the game of defending the value of such goats in such a manner generally does work and has worked for a very, very long time. Much of the worlds trade is done using currencies built on such circular constructs. Perhaps it looks flawed but empiracly it works.

However lets imagine now that Fred owes too many goats and his business has stagnated and he decides that he will default on his debts. Now those “IOU goats” will be worth next to nothing because Fred is no longer credible financially. And if those assets are worth next to nothing then suddenly we have no assets with which to defend the value of goats. Suddenly the game is up and all it takes is a slight breeze and the house collapses, along with the currency.

In summary and putting it back into real world terminology I’d say that given the asset profile of the US central bank the collapse of the US dollar is possible on two counts. One is if the dollar declines rapidly and as it does so it takes down the value of the assets in a vicious circular decline. Perhaps it would be prudent for the US central bank to have a more diversified asset base. Some gold perhaps. Maybe some more EUROs. However ultimately I don’t think the long standing game of defending the value of dollars with “IOU dollars” is suddenly going to stop working on this basis. It is a robust well tested technique in spite of it’s apparent circular nature.

The second way the dollar could collapse is if the US government can’t repay it’s debts. If this happens then on reflection I’d be inclined to agree with Ron Paul. Currency collapse could come extremely rapidly. And in this situation the central bank, in spite of all the best intentions in the world, and even if they employed the best brains in the world, couldn’t then escape such a vortex. Certainly not with US bonds as a primary asset base.

A counter point might be that if the US dollar collapses in this way then so will the other currencies of the world if the respective central banks hold primarily US dollar assets as their backup. So maybe we have a synchronised collapse and the US dollar doesn’t fall 80% against the EURO because the EURO also collapses. None the less the collapse would be felt relative to real goods in the form of extreme inflation.

Is any of this likely? Personally I think the USA can avoid default on it’s debts. It is AAA rated so not likely if ratings still mean anything. Also as I said in the beginning they have a huge proportion of the worlds production. They have enormous scope to cut government spending (eg military expenditure) to turn their government finances around. They have lots of smart people. I’d like to think that smart people with lots of resources can avoid impoverishing themselves through excessive government debt.

72 thoughts on “Could the US dollar collapse?

  1. Terje

    The AFR had an interesting table this morning on which country is most likely to default – the US came about 9th (of major economies). Most likely candidates are Ireland and Portugal. Australia was one of the least likely.

  2. The US dollar MUST collapse. The only reason it hasn’t done so is that banks all around the world have been expanding the money supply even worse than the Americans.

  3. Terje:

    The US dollar is not going to collapse. The Euro and the Yen are.

    I presume you means collapse against gold? That’s possible, but it will collapse less than the other two.

  4. “I don’t think there’s any real value in ratings today. That’s obvious, from the way they rated a lot of the structured products as investment grade.

    The agencies have undermined their brand creating a caveat emptor reputation rather than one of trustworthiness.”

    -Peter Schiff

  5. In the short-run at least, I think it more likely that the USD will appreciate.

    I share your view that the Fed is aware of this risk and will act to prevent it. Indeed it already has. Overnight the Fed raised the discount rate from 0.5% to 0.75%. And some time soon, it will inevitably lift the Federal Funds rate as well as the newly created Interest On Excess Reserves (IOER) rate.

    But Bernanke began monetary tightening as far back as March last year. The most recent M2 data shows an annualised growth rate of just 1.8% – the lowest in close to 15 years. The real danger, therefore, is not a collapse in the dollar, but a collapse (double-dip) in the US economy! I might add that our own RBA has been quietly, but aggressively, tightening money supply growth as well. And so, apparently, have the Chinese.

    If I am right (?!?!), we will shortly experience a drop in the AUD, the price of gold and a collapse in the share market.

    I read somewhere that one of the ratings agencies may downgrade the USA’s AAA rating.

  6. The most interesting thing about currency collapses is that just before collapse no one really believe it will happen. The total amount of money that changes hands in one day is usually a tiny tiny amount of the money that people hold. Once people loose confidence and try to spend all their money at once, you can get inflation of hundreds of percent in just a few days – even without the money supply expanding.

    Contrary to what most people believe Zimbabwe/Germany did not have problems from printing money like crazy, they had problems because no one was willing to hold it for any period of time once confidence was lost from printing a little bit of money. Indeed Zimbabwe pre-printed its dollar several times on carefully selected amount – but if no one is willing to hold it, it has no time value, and it inflates – even with no further printing.

    Also I think people are still over doing it with these dooms day scenerios. Despite what people say about USA running a huge decifient, there interest payments are still not that big, there taxes are low. The goverment has a $2,000 billion deficient, Bill Clinton turned a $300b debt to a $500b credit in a few years. Some right tax moves and spending cuts could turn the whole thing around very abruptly. They are not bankrupt until they have absoultely no way to pay there interest, they are miles and miles away from this. They will cut welfare long before the their dollar collapses. By the time the dollar collapsed in most other counteries the social systems had long been closed.

  7. Mundi – lots of good points.

    JC – this article isn’t about gold or the gold standard. It is about the collapse of the US dollar. Feel free to read what I wrote.

  8. Mundi you have a point and Obama can turn things around if the will exists. The problem lies with multi level debt and unfunded liabilities, and contingent liabilities, on top of the current debt – and if Obama continues to engage in such ruinous activity such as more Keynesianism or an ETS, and the tax base collapses.

  9. I think JC is right… the US dollar may suffer inflation, but I doubt it will collapse (or even semi-collapse) against the Euro.

    Terje was very thorough, but I think there is an easier way to explain this: while foreigners continue to want to invest in America, their dollar will remain high… if foreigners lose faith in American financial assets (particularly including government bonds), then their dollar will drop.

    At the moment, I think US bonds are still a relatively safe bet. Especially when you compare them to Greek or Portugese Euro bonds. I’m not particularly optimistic about Japanese bonds either.

    There is another issue at play, and that is the fact that the USD is used as a defacto international currency. That means that the Fed is actually able to get away with a bit more printing than other countries without suffering as much of an inflationary hangover. Lucky bastards.

    Compared to that mob of misfits, Australia is in a pretty good position, due to the decent macro-economic policies of the past 20 years. Let’s home Rudd isn’t intent on ruining it.

  10. Terje

    You misunderstand my point. If you want to leave gold out of it fine by me and I’ll explain my point this way.

    The US dollar will not collapse against any of the major currencies in the world and will likely strengthen significantly against the Euro and the Yen. The last two currencies are to most likely candidates for a true collapse.

    We will likely see a float of the Yuan and it may take an important role in the world’s currencies along with the Brazilian Cruz.

    The real risk to the world’s monetary system will in fact be the Euro as the union is dysfunctional. The Yen will eventually collapse by the sheer weight of the debt and the frightening demographics.

  11. I think Peter Schiff still writes economic scenarios for Ron Paul. A smart man but, sometimes his analysis leaves a bit to be desired.

  12. If Greece defaults on government debt it will not bring down their currency. In fact I think default might be a good option for Greece.

    JC – what aspect of EU disfunction do you think threatens the EURO. Personally I think the ECB is better run than the Fed.

  13. John – I don’t think your easier explaination actually explains anything. I think it is merely an assertion. An assertion that still needs an explaination.

  14. Greece isn’t the problem. The PIIGS are the problem. You can’t have monetary union without fiscal union and no matter what you think of the Fed the structural surroundings of the US monetary system are far sounder than the EU.

    The EU will break apart as I can’t see how it can hold the edges, or the follow an inflationary policy.

    If there are severe problems in California, there are automatic stabilizers from the rest of the country. You don’t have that in Europe.

    But go ahead gives us a lesson on how Europe’s system is superior, as I would like to hear it.

  15. You can’t have monetary union without fiscal union

    Clearly you can because the eurozone exists. I think you’re saying that you shouldn’t. I wish you would spell out your reasons rather than merely assert it as some form of metaphysical fact.

    The EU will break apart as I can’t see how it can hold the edges, or the follow an inflationary policy.

    Again I wish you would spell out your reasons.

    But go ahead gives us a lesson on how Europe’s system is superior, as I would like to hear it.

    I think the ECB is superior in that it appears to have a clearer mandate. Why do you think the Fed is superior?

  16. I wish you would spell out your reasons rather than merely assert it as some form of metaphysical fact.

    (Not the snarks again).

    I did. I’ll repeat it again or rephrase it.

    “You can’t have monetary union without fiscal union and no matter what you think of the Fed, the structural surroundings of the US monetary system are far sounder than the EU.”

    And the example of the “metaphysical”

    If say California has economic problems there are automatic stabilizers set up at the Federal level that help ease the stress in that state through direct transfer payments. Unlike EU member states, US states are not allowed to borrow under their “sovereign” name, although they get around this by creating off balance sheet structures and direct borrowings against specific projects.

    The other point to add is that the structure of the EU’s weaknesses doesn’t show up until the system is stressed and it’s pretty well stressed now.

    Clearly you can because the eurozone exists. .

    Cardboard boxes will also suffice as housing for a while until there’s wind, rain or both and in this case the EU have both.

    Again I wish you would spell out your reasons.

    The southern region of the EU has maintained a policy tolerating high level of inflation and devaluation/currency depreciation to maintain social cohesion while the northern regions haven’t. As hard as it to believe, the northern part is also far more flexible and nowhere near as spendthrift and in some cases like Greece totally dishonest in the way they manage fiscal policy. The South has been a profligate and wasteful spender with large public sectors. In previous times Greece would simply devalue the currency and take the hit in living standards through currency depreciation instead of having to do so through real prices as they are expected to now. Lowering the standard of living through hikes in nominal prices had been far more acceptable to them than through cuts in real prices :read real wage cuts as they EU is demanding now.

    I think the ECB is superior in that it appears to have a clearer mandate. Why do you think the Fed is superior

    I think the ECB is actually pretty decent however the system they operate under is dysfunctional without fiscal federation and consolidation of a large part of member budgets handled at the federal level like it is in the US. They’re all going broke, but some (the PIIGS) are going broke faster than others in trying to maintain bloated welfare and enormous public sectors.

    The EU may survive, however the ECB will have to move to a monetary policy suiting the weaker members rather than the stronger, which means it will have to tolerate much rates of inflation than it does now. I really don’t know if the north is prepared to be this explicit.

    Frankly the conspiracy theorist in me thinks they are more than well aware of this, which is why we saw a recent hike in the US discount rate and the IMF sounding out again its decision to sell more gold. The Euro could end up head to below 1.00 over the next 1 to 2 years if this system is going to survive.

    I believe the people suggesting a collapse in the US dollar against these two other major currencies are clueless.

  17. How are the stabilizers that California can access anything other than a form of Keynesian fiscal stimulus. If fiscal handouts work in this case then don’t they always work? And if they do work then why do they work any better than state bases borrowing and spending? If California was allowed to borrow then in a local downturn it could effectively borrow from other states and provide transfers on it’s own terms.

    Unlike the US the central EU authority (government) has very limited borrowing capacity. I actually think this is a superior arrangement because it means more accountability for government debts and less systemic risk across the totality of the region.

    Yes the EU is stressed at the moment but so is the US. In what ways is the stress causing problems in the EU that are not also apparent in the US.

    In terms of policies that tolerate high inflation I don’t see how this makes sense. The EU has a single monetary authority. Yes there may be regions with rising aggregate prices but this is also true in US regions. Price stability across a region does not mean price stability in the sub-regions. I don’t see the EU as being unique relative to the US in this regard.

  18. How are the stabilizers that California can access anything other than a form of Keynesian fiscal stimulus.

    We’re not talking about changing the economic system into a libertarian one; we’re talking about the failure of the EU and the potential collapse of the Dollar. Discussion about the Keynesian model is another topic in the sense that we’re working with the system we have.

    If fiscal handouts work in this case then don’t they always work?

    They certainly help reduce the impact of a collapse in say California’s tax receipts.

    And if they do work then why do they work any better than state bases borrowing and spending? If California was allowed to borrow then in a local downturn it could effectively borrow from other states and provide transfers on it’s own terms.

    See above about keeping the debate within the current parameters of the economic systems.

    Unlike the US the central EU authority (government) has very limited borrowing capacity. I actually think this is a superior arrangement because it means more accountability for government debts and less systemic risk across the totality of the region.

    That’s a different argument entirely. The point is that the central government in the EU is weak and the member states are the ones that ultimately call the shots. At the same time they are fearful of Greece defaulting or actually taking to the printing presses themselves as there really isn’t that much to stop them from doing so.

    Yes the EU is stressed at the moment but so is the US. In what ways is the stress causing problems in the EU that are not also apparent in the US.

    Tell that to the market that placed the entire southern flank of the EU on default watch.

    In terms of policies that tolerate high inflation I don’t see how this makes sense. The EU has a single monetary authority. Yes there may be regions with rising aggregate prices but this is also true in US regions. Price stability across a region does not mean price stability in the sub-regions. I don’t see the EU as being unique relative to the US in this regard.

    Don’t argue your metaphysics. Tell us why you think so; supported with a little more evidence that.

    The US monetary system is piss-poor at the moment, however it’s miles more robust than the EU’s.

    Here’s a great discussion about the non-collapse of the dollar by someone I think is quite possibly the best monetary economist in the country: Steve Kirchner who ought to be the governor of the RBA.

    http://www.institutional-economics.com/index.php/section/comments/the_future_of_the_us_dollar/

  19. Discussion about the Keynesian model is another topic in the sense that we’re working with the system we have.

    And the system in the US involves “automatic stabilizers”. I’m trying to discern why you think these are so critical. The Californian government can make up for a fall in revenue by getting handouts from the feds. At other times money will be transfered out of California to other parts of the US. Meanwhile Greece can borrow in the tough times and pay back in the good times. Why is one form of fiscal stimulus superior to the other? I’m trying to figure out why California is in your view better off and I can’t see it. I’m not trying to change any parameters. In fact I’m not really trying to even debate you at this point I’m just trying to understand your reasoning.

    That’s a different argument entirely. The point is that the central government in the EU is weak and the member states are the ones that ultimately call the shots. At the same time they are fearful of Greece defaulting or actually taking to the printing presses themselves as there really isn’t that much to stop them from doing so.

    I think it is good that central government is weak and that regional governments call the shots. This is how the US used to be and there is much historical evidence to suggest that it is a better state of affairs. So long as Greece retains the Euro I don’t understand how there is any prospect of them using the printing presses. And if they retain the euro and default I have trouble seeing how this effects the other EU nation states. I accept that the EU central government is weak but I don’t understand why you would want it to be stronger. What would be the benefit.

    Tell that to the market that placed the entire southern flank of the EU on default watch.

    Why is this a concern? If they default then what. I think the only ones that should really worry about a default in Greece are bond holders.

  20. And the system in the US involves “automatic stabilizers”. I’m trying to discern why you think these are so critical. The Californian government can make up for a fall in revenue by getting handouts from the feds.

    California belongs to a federation. I’m not arguing if the transfer payments are good or bad, but in the event that California finds itself in a recession other regions of the US come its aid indirectly through social security transfers and other support payments.

    Meanwhile Greece can borrow in the tough times and pay back in the good times. Why is one form of fiscal stimulus superior to the other?

    How can Greece be able to borrow a dime now unless it is usurious? California doesn’t have a borrowing issue as much as it has a huge problem with meeting recurrent spending seeing it’s not allowed to borrow under it name as the states are constitutionally precluded from doing so. They can find some ways around this by borrowing under specific projects with on-going revenue streams. Greece on the other hand needs to roll over 125% of its GDP and there aren’t any constraints on size despite there being limitations through the Maastricht accord.

    I think it is good that central government is weak and that regional governments call the shots. This is how the US used to be and there is much historical evidence to suggest that it is a better state of affairs.

    Not when you’re running welfare states the size we are it isn’t. Ordinarily Greece would have been shunted out of the capital market long ago as they wouldn’t have been trusted and their borrowing spreads would have made it impossible. The Euro essentially allows them to piggyback on Germany’s credit rating, as the markets don’t believe the Greeks would be allowed to default and the Greeks know that too. Hence the moral hazard issue.

    So long as Greece retains the Euro I don’t understand how there is any prospect of them using the printing presses.

    How do you know? That’s what investors what to know. They’ve lied before, so why would you trust them not to print more money?

    And if they retain the euro and default I have trouble seeing how this effects the other EU nation states. I accept that the EU central government is weak but I don’t understand why you would want it to be stronger. What would be the benefit.

    If you have a weak central government you don’t want the member states having the ability to go out and borrow as much as they want. There should be constraints on them.

    Tell that to the market that placed the entire southern flank of the EU on default watch.
    Why is this a concern? If they default then what. I think the only ones that should really worry about a default in Greece are bond holders.

    That’s fine by me. Let them default. However you’d find that the stronger members wouldn’t want to have the capital markets start placing a cost on them as a result of default risk caused by the member states.

    Sovereign default by the south would essentially tarnish the perception of the Euro and would put it into question.

  21. The Euro essentially allows them to piggyback on Germany’s credit rating, as the markets don’t believe the Greeks would be allowed to default and the Greeks know that too. Hence the moral hazard issue.

    I think this is the crux of our differing opinion. I may be wrong in practice but in theory I don’t see how the credit worthiness of Greece and Greek bonds should impact on the Germans and Getman bonds so long as neither is liable for the debts of the other and the printing presses are controlled by the ECB and it cares only about price stability. It is an open question as to what would happen if Greece defaulted on it’s debts but my opinion is shaped by an assumption that their credit rating would hit rock bottom, the ECB would keep the printing press in check and the rest of the EU would say tough luck Greece. Perhaps I’m misinformed about the institutional arrangements or else naive about the politics but in any case I hope you can at least see the basis for my current opinion. And assuming you can then the areas in which evidence is needed in order to close the gap between us should then be quite self evident. And I’ll be the first to admit that in those areas my evidence is mostly annecdotal. I’m quite open to the posibility that it is my view that needs to change but obviously it isn’t going to until some evidence suggests a need to. In short I respect the strength of your convictions but they are not in themselves sufficient to persuade me.

  22. p.s. Do euro bonds issued by different euro nations trade at a different risk premium? I assume they do but if they don’t then I would regard this as evidence that I’m missing part of the puzzle.

  23. I’m not in the least trying to persuade you one way or another.

    In summary I think the Dollar will be around for a lot longer than the Euro and even perhaps the Yen.

    I may be wrong in practice but in theory I don’t see how the credit worthiness of Greece and Greek bonds should impact on the Germans and Getman bonds so long as neither is liable for the debts of the other….

    Theory is fine in a text book. It’s the practice we should have a problem with.

    http://www.reuters.com/article/idUSLDE61J05O20100220?type=marketsNews

    You are not serious that the Greeks aren’t pigg packing off the Germans and the rest of the core by using the single currency.

    You honestly think Greece would have been able to borrow at pennies above German bunds if they still had the Drachma?

    Please explain how?

  24. You honestly think Greece would have been able to borrow at pennies above German bunds if they still had the Drachma?

    No I don’t. I have said nothing of the sort so I don’t know where this inference comes from. Clearly Greek issued euro bonds (or Greek issued dollar bonds for that matter) are going to be much more trusted than the Greek issued Drachma bonds of old. Euro bonds by definition are denominated in Euros and the Greek government does not have the power to devalue the euro hence the bond is more reliable. There is however still the risk of an outright default.

    Earlier I asked:-

    Do euro bonds issued by different euro nations trade at a different risk premium? I assume they do but if they don’t then I would regard this as evidence that I’m missing part of the puzzle.

    The following news article makes clear that they do:-

    http://www.news.com.au/business/breaking-news/pressure-eases-on-greek-bonds-after-eu-pledge/story-e6frfkur-1225829551142

    The spread — or difference in interest rate — between Greek bonds and the German Bund dropped to 2.73 percentage points compared to 3.24 points a day earlier.

    The yield on the German Bund rose to 3.238 percent, up from 3.195 percent on overnight.

    The yield on Greek bonds dropped after Europe pledged solidarity with debt-stricken Greece at a summit in Brussels on Thursday.

    This confirms that each euro nation is evaluated on it’s merit when it comes to credit worthiness. However it also unfortunately signals a willingness on the part of euro nations to bail out their neighbours. This is silly in terms of moral hazard and as evidenced by the rise in the rate on German bonds it is also contrary to self interest.

  25. I said:

    “You honestly think Greece would have been able to borrow at pennies above German bunds if they still had the Drachma?”

    You said.

    No I don’t. I have said nothing of the sort so I don’t know where this inference comes from

    Well you did by the fact that you refused to accept the assertion that Greece is piggy backing off the stronger North.

    That’s what piggy backing means amongst other things. If the Greeks had the Drachma the currency would have fallen by a large amount as domestic and external would have escaped what would have been a certain and severe depreciation of the domestic currency well before they reached this point.

  26. Well you did by the fact that you refused to accept the assertion that Greece is piggy backing off the stronger North.

    It does not follow from this at all. The Euro does not belong to the north. It is a single currency used across the eurozone. It is managed by the ECB. There is no piggy backing. The Germany government does not guarantee Greek government debt unless it decides to. If it decides to then I would agree with the piggy back analogy but Germany has not made any such decision. Nor should it.

    In any case even if parts of the eurozone do piggy back of other parts it still isn’t clear how this is any different to the situation in the USA. Your opening argument seemed to be about how automatic stabilizers allow California to get carried by her neighbours. Isn’t this just a case of automatic piggy ride?

  27. It doesn’t follow because you deem it or because of some other evidence?

    I presented you with a plausible argument that Greece would have been thrown out of the international bond markets a long time ago if it hadn’t been part of the Euro and just kept the drachma. It would not have been able to borrow such large sums without the implicit German guarantee and the fact that no one would have trusted the Greek currency not to crash causing immediate default.

    You say it doesn’t follow. Fair enough. I don’t have anything to add to to that suffice to say that you deeming something doesn’t follow makes no difference to the facts.

    You deal in the make believe theory of what you want to believe and then when the theory is shown that it doesn’t work in practice as the other, larger members are working out a bailout package for Greece, you seem to agree.

    Take that a few more steps ahead and ask yourself what happens when the other PIIGS want a bailout in case they are denied credit? What happens then?

    Default isn’t that easy when you have possibly a trillion Euro in question. It would wreck the integrity of the Euro. The Euro would possibly collapse sending import costs sky high ruining good economies in its wake.

    The question about California is nonsense. California doesn’t have a massive debt overhang. It has a annual deficit that it must make up either with cuts or tax increases. The other thing is that monetary union and the Greenback are over 150 years old.

  28. The Greek euro bonds are not more credible than the drachma bonds because they are backed by Germany. They are more credible because Greece could elect to devalue the drachma but can’t elect to devalue the euro. The fact that there is a spread between German euro bonds and Greek euro bonds demonstrates that the market evaluates the risk of each borrower separately.

    A Greek default primarily threatens the euro in so far as the ECB is a holder of Greek euro bonds.

    I don’t dismiss your point as it does carry some validity. However I do think the primary strength of the Greek euro bonds relative to drachma bonds is about their inability to devalue. The euro has imposed a positive discipline. I don’t think a devaluation would be better. And I whilst a Greek default would cause some sence of crisis I don’t think it would significantly impact the euro.

  29. I’d say that the ECB may bail out the PIIGS. But this could in the long run lead to the breakdown of the EU or EMU.

    Hopefully they’ll get on top of things fiscally. Many EU countries don’t qualify for membership under their own rules.

    The problem happens Terje because the adjustments internally or externally are more unpredictable than in the US or here.

    If the Euro falls to parity with the USD, how will each country adjust with prices, wages and external balances? Britain isn’t part of the EMU, only the customs union.

  30. If the US dollar DOES collapse, what would be the effect on our dollar? Would we seem a safe haven for foreign investors, or would the Australian economy be too small to worry about?

  31. The Australian economy is small but it is attractive. If the US dollar collapsed, there would be compensatory effects on us – 1. the unattractiveness of the US vs 2. the appreciated price of Australian assets.

    What might see is a large inflow of long term private equity financing (foreign direct investment) into the US. There would be arbitrage for investors on technological superiority but also the US would need the investment to rebuild their capital base, along with their tax base to repay the debt.

  32. And I think that Cuba and North Korea and the Taliban would be happy if the dollar collapsed, so there are some people who think it would serve their interests.

  33. semi – I don’t agree at all. Collapsing may be compatible with floating but that does not mean either or both is a good thing.

  34. The Greek euro bonds are not more credible than the drachma bonds because they are backed by Germany. They are more credible because Greece could elect to devalue the drachma but can’t elect to devalue the euro.

    Yea, which is what I said earlier amongst other things.. What’s your point?

    The fact that there is a spread between German euro bonds and Greek euro bonds demonstrates that the market evaluates the risk of each borrower separately.

    Within the confines of the Euro it does.

    However I do think the primary strength of the Greek euro bonds relative to drachma bonds is about their inability to devalue.

    I would argue that it’s the inability to devalue or avoid a total collapse of the currency. Both.

    The euro has imposed a positive discipline. I don’t think a devaluation would be better.

    As I said earlier about some other point you made. It doesn’t matter what you think. It’s the reality of the situation that we have to worry about. These economies are relatively inflexible with large welfare appendages and huge public sectors with a system that only knows who to raise wages either nominally on in real terms. They haven’t experienced disinflationary tugging like this, which is why there are lots of people who doubt whether the system can survive. There is also little labour mobility as you see in the US.

    And I whilst a Greek default would cause some sence of crisis I don’t think it would significantly impact the euro.

    Fair enough, then you must think the Euro is a great buy here. You know what to do.

    Greek default wouldn’t necessarily hurt the euro by itself theoretically. However if Greece defaults markets would immediately impose serious default risk on the other weaker members, which is why this thing is dangerous. Now don’t tell me that if there were a combined default it wouldn’t hurt the Euro.

  35. A combined default would hurt the euro if it wipped out a significant stock of ECB asserts. I have not studied the ECB assert portfolio in detail. At a guess it is a more diversified portfolio than what the fed has.

    Why would I buy the euro just because I don’t think a Greek default will cause a collapse? I’d buy it if I thought it was more likely to go up than down but I don’t know if that is the case.

  36. You think a combined default would just hurt the Euro? Lol. I guess you would be the most optimistic person on the planet if you think that’s all it would do.

    I have not studied the ECB assert portfolio in detail. At a guess it is a more diversified portfolio than what the fed has.

    And you’d guess that because… that’s what you’d like to believe? The ECB has $450 billion of the Fed’s money lent during the crisis to help the ECB alleviate another crisis it was dealing with inside the EU, which was a severe dollar shortage.

    You should buy the Euro because you sound very optimistic about it’s chances of surviving and that defaults don’t really matter under your theoretical floor.

  37. Buying it because it will survive isn’t profitable. To be profitable it would have to go up.

  38. not all, but there’s a decent number of people who think it won’t survive in its current state. If they’re wrong it will go back up. There’s a trade here.

  39. Terje, you lost me at the beginning when you decided to compare the US dollar against the Euro.

    Sorry, but the Euro will hardly be some stable benchmark of value and worth. It has more problems than any other currency and I think the comparison should be done against gold.

  40. jono:

    don’t say that or you get this reply:

    JC – this article isn’t about gold or the gold standard. It is about the collapse of the US dollar. Feel free to read what I wrote.

  41. JC – now who is being snarky?

    Jono – I did say that it was merely for the sake of conversation. And I acknowledged that the collapse of one could in theory occur at the same time as a collapse in another. This article wasn’t intended to be a US dollar versus the Euro debate. Personally I think the chance of either collapsing is currently remote. Just because I discuss systemic weaknesses does not mean those weaknesses are currently material.

  42. JC – assuming that Greece is on the brink of insolvency how likely do you think it is that there would be a bailout by other nations? Either via the IMF or directly by other euro nations. As indicated previously I don’t think there should be a bailout, and there are a few institutional obstacles, but as you indicate that doesn’t mean it won’t happen.

    John Quiggin has offered the view that Greece should try and honor it’s bonds but should default on the less than transparent debts incurred by the previous government. I’m very sympathetic towards that position but I don’t know all the relevant history.

  43. Hard to tell what happens to be honest. However I think a sovereign default of a western nation even small Greece may turn out to be a pretty big deal as it would shatter confidence in the entire edifice of the Euro and perhaps the bond market.

    You/we may want to see governments borrow little to no money, however you really don’t want to see it happening like this. You don’t want to see a shut out…. you want to see a move away from needing to borrow like we did.

    You never know where that shit ends up.

    I think the Euro is a failed project, or rather its enlargement was. There was never a real concern with the core (the north +france) as those nations could easily be integrate.

    The south however has always taken the vast bulk of its adjustment through currency depreciation.

    The perception that the Euro would keep the riff raff south in check would be seen as a lie and the accords to hold nations within an acceptable budget target is shown to be bullshit too.

    This is where the rubber meets the road as far as I’m concerned.

    The ECB either begins a much softer monetary policy that is perversely framed by the weaker members or the whole thing breaks apart.

    I think the ECB will begin a softer policy.

    On the matter about the previous government’s lack of transparency. Goldman Sachs claims their swap was totally transparent, didn’t break any EU, US or Greek laws, the details of the swap was actually publish in the swap magazine at the time and the Greek government reported it domestically.

    If that’s the case what laws were broken or what transparency was avoided?

    The thing is that I’m trying to stay focused on how we manage through this current economic system we have. Theory is fine, but it’s not reality, which is why I have taken some of the views i have earlier up-thread.

  44. I suspect that some of our dialogue was at crossed purposes. The intersection between economic theory and political reality is dicey.

    I agree that default isn’t the ideal way to correct over spending. However if it is allowed to happen I suspect it will.

  45. Any comment, Terje?

    Germany, France Mull 30 Billion-Euro Aid for Greece, WSJ Says

    By Shiyin Chen

    Feb. 28 (Bloomberg) — Germany and France are considering a plan to bail out Greece that could cost as much as 30 billion euros ($41 billion), the Wall Street Journal reported, citing an unidentified person familiar with the situation.

    The plan would involve the sale of Greek bonds to French and German organizations, most likely state-owned banks, as well as to the public, the newspaper said on its Web site. The timing of the deal, which would require the approval by German and French officials, is not yet clear, according to the report.

  46. It would be a bad move. In essence it amounts to a bailout of those holding Greek bonds. It will encourage poor fiscal decisions in other EU nations. However there are lots of voices opposing such a bailout so we will see what happens.

  47. “At the moment, I think US bonds are still a relatively safe bet.”

    This is an utterly delusional contention. People can you get it together? If the USD doesn’t collapse it will only be because the other countries are even worse counterfeiters than the Americans.

  48. JC – I’m increasingly of the view that Greece won’t get bailed out by other EU nations even whilst they will offer some moral support. Greece will have to get it’s budget in order which will mean the euro straight jacket is working.

  49. Or perhaps they get bailed by the IMF which seems what the Germans are angling for. Dunno, but it’s worth watching.

  50. So far the market is only demanding 6% to lend to Greece. I can’t see why they would hand over to the IMF unless things get a lot worse. And if things do get that bad then they may be better of just defaulting and starting fresh.

  51. When it gets into heavy duty political realm I always find it better to stand away and not try to predict the outcome.

    It seems to me that Angela Merkel would like to lend a hand however the German voters are deadset against it, which is why we keep hearing contradictory statements.

    Recently I read the IMF was sniffing around looking to see if they could lose their contributors money.

  52. It seems they’ve just bailed out Greece. It will be interesting to see what they do with the other ratbags as they too will want their bailout.

    they’ve just built their own coffin.

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