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As the global reserve currency, the dollar finds itself in the
position of being a global "network good." A "network
good" derives its utility to the user (its value) from the "network
effect," the number of other people also using it. A "network
effect" is normally a self-reinforcing positive feedback loop. The more people that
use a "network good," the more valuable it becomes and then more
people use it, and so on.
A few random examples of a "positive network effect" are Facebook, Wikipedia, eBay, the Internet, the NYSE,
perhaps even this blog. The opposite of "network value" is
"inherent value." In the latter, you derive value from simply using
a good. In the former, you derive value from other people's use of the
good. If we all stopped posting on this blog tomorrow it might have some
residual inherent value left in the old archives, but the network value would
be gone.
Two big threats to network value are complacency and competition. The
complacency of the network operator and the emergence of competing networks
tend to begin the process of negative feedback. A few examples of a
"negative network effect" are AOL, the USPS, the New York Times and
the U.S. dollar.
For the last 88 years or so the dollar has expanded into many global uses
that today lend it its only value, its "network value." More things
are priced in dollars today than any other currency, to provide easy
calculation and transparent pricing across the globe. More contracts are
denominated in dollars today, invoiced in dollars, settled in dollars, and
more savings are denominated in dollars today than any other currency.
But despite its popularity, the dollar still has two fundamental flaws. The
first flaw is that it is a national currency, not a supranational one, and
the second is that it once tried to be as good as gold. So much so that even
today the dollar cannot sever its link to gold. From the U.S. Treasury's
FAQ's on its own website:
Under 31 U.S.C. 5118(b) as amended, "The United States Government
may not pay out any gold coin. A person lawfully holding United States coins
and currency may present the coins for currency . . . for exchange (dollar
for dollar) for other United States coins and currency (other than gold and
silver coins) that . . ." citizens may lawfully own. Although gold
certificates are no longer produced and are not redeemable in gold, they
still maintain their legal tender status. You may redeem the notes you have
through the Treasury Department or any financial institution. The redemption,
however, will be at the face value on the note. These notes may, however,
have a "premium" value to coin and currency collectors or dealers.
Back to that first flaw, the dollar is the national currency of a single
nation-state, yet it is also held globally as a reserve currency to serve all
of its global uses, which in turn give it value even today through the global
network effect. So how is this a flaw? Well, it
leads to a conflict of interests between the issuing nation-state's internal
and external obligations as manager of the currency. This is called the Triffin Dilemma.
From Wikipedia: The Triffin
dilemma (less commonly the Triffin paradox) is the
observation that when a national currency also serves as an international
reserve currency (as the US dollar does today), there are fundamental
conflicts of interest between short-term domestic and long-term international
economic objectives. This dilemma was first identified by Belgian-American
economist Robert Triffin in the 1960s, who pointed
out that the country issuing the global reserve currency must be willing to
run large trade deficits in order to supply the world with enough of its
currency to fulfill world demand for foreign exchange reserves.
The use of a national currency as global reserve currency leads to a tension
between national monetary policy and global monetary policy. This is
reflected in fundamental imbalances in the balance of payments, specifically
the current account: some goals require an overall flow of dollars out of the
United States, while others require an overall flow of dollars in to the
United States. Currency inflows and outflows of equal magnitudes cannot both
happen at once.
The Triffin dilemma is usually used to articulate
the problems with the US dollar's role as the reserve currency under the Bretton Woods system, or more generally of using a
national currency as an international reserve currency.
Onset during Bretton Woods Era
Due to money flowing out of the country through the Marshall Plan, US
defense-spending and Americans buying foreign goods, the number of U.S.
dollars in circulation began to exceed the amount of gold backing them up in
1959.
By the fall of 1960, an ounce of gold could be exchanged for $40 in London,
even though the price in the U.S. was $35. This difference showed that
investors knew the dollar was overvalued and that time was running out.
The Nixon Shock
In August 1971, President Richard Nixon acknowledged the demise of the Bretton Woods system. He announced that the dollar could
no longer be exchanged for gold, which soon became known as the Nixon shock.
The "gold window" was closed.
In order to maintain the Bretton Woods system the
US had to:
a) run a balance of payments current account deficit to provide liquidity for
the conversion of gold into US dollars. With more US dollars in the system
the citizens began to speculate, thinking that the US Dollar was overvalued.
This meant that the US had less gold as people starting converting the US
dollars to gold and taking it offshore. With less gold in the country there
was even more speculation that the US Dollar was overvalued.
b) run a balance of payments current account surplus
to maintain confidence in the US Dollar.
Obviously, the US was faced with a dilemma because it is not possible to run
a balance of payments current account deficit and surplus at the same time.
Implication in 2008 meltdown
In the wake of the Financial crisis of 2007-2008, the governor of the
People's Bank of China explicitly named the Triffin
Dilemma as the root cause of the economic disorder, in a speech titled Reform
the International Monetary System.
It is clear, at least to me, that today we have the mother of all tensions
between national monetary policy and global monetary policy. The Triffin paradox is in full bloom! The dollar is
exhibiting its contradictory nature in view of the world. As Costata asked in a recent comment: Are the US external
creditors and issuers of the currencies affected by these policies going to
stand for this?
Meanwhile, as the dollar (mis)management was busily
becoming complacent, a new competitor emerged. On January 1, 2002, euro notes and coins were
introduced to twelve nations as a new medium of
exchange. On January 18, 2002 it was announced that the Charlemagne Prize, which is normally given to people the likes of queens, presidents
and Popes, would be awarded to a thing, the new euro. During his acceptance
speech, President of the ECB, the late Dr. Willem F. Duisenberg said this
about the euro:
The euro is the first currency that has not only severed its link to
gold, but also its link to the nation-state.
My hope is that I have now armed you with what you need to understand the
meaning of this powerful statement. The euro solved dollar flaw #1, the Triffin dilemma, by severing its link to the
nation-state, and dollar flaw #2, trying to be as good as gold, by severing
its link to gold. It did the latter through the Eurosystem
quarterly mark to market reserve policy. And let's take a quick look at the
results thus far:
Tuesday, January 1, 2002 - ***"E-Day" Launch of euro notes***
(with reserves of about 12,500 tonnes of gold)
Friday, February 8, 2002 - *** GOLD ABOVE $300 ***
Monday, December 1, 2003 - *** GOLD ABOVE $400 ***
Thursday December 1, 2005 - *** GOLD ABOVE $500 ***
Monday, April 17, 2006 - *** GOLD ABOVE $600 ***
Tuesday, May 9, 2006 - *** GOLD ABOVE $700 ***
Friday, November 2, 2007 - *** GOLD ABOVE $800 ***
Monday, January 14, 2008 - *** GOLD ABOVE $900 ***
Monday, March 17, 2008 - *** GOLD ABOVE $1000 ***
Monday, November 9, 2009 - *** GOLD ABOVE $1100 ***
Tuesday, December 1, 2009 - *** GOLD ABOVE $1200 ***
Tuesday, September 28, 2010 - *** GOLD ABOVE $1300 ***
Thursday, October 14, 2010 - *** GOLD ABOVE $1375 ***
Please think back to what the rise in gold during the 1970's did to the
dollar and the international monetary system. It panicked European central
bankers to the extent that they confronted Paul Volcker in October 1979 at an
IMF meeting in Belgrade, Yugoslavia with "stern recommendations"
that something drastic had to be done immediately to stop the dollar's fall.
The fear among the European central bankers at the meeting was that the
global financial system was on the verge of collapse.
Now compare that to today. As the gold price rises, the euro's
monetary reserve assets rise in both value and confidence. They know that
even if the dollar collapses today, the gold portion of their reserves will
more than compensate for the loss of dollar-denominated assets. And they also
know that today, unlike in 1979, there is an alternative currency of
sufficient size and scope to pick up the global financial slack. No need to
panic like 1979.
I'm sure that right about now some of the noobs
(and a few regulars) are scratching their heads thinking, "why is a gold
bug like FOFOA praising the euro? It's just another fiat currency, isn't
it?"
First of all, I'm not a gold bug. Second, my praise has nothing to do with
Europe's Socialist infrastructure or its politics, which are a mess. As
ANOTHER said, Europe's politics are "a side show," easily
subservient to the monetary structure which evolves on long-line cycles.
Politicians like to pretend things can change on short cycles, with their
help. But the euro has been in the works since 1962. And to those that
believe short-line politics will break countries like Greece away from the
euro, all I can offer is "time will reveal its long-line nature…
in time."
Third, I share with Aristotle the following A-HA moment which he described here:
In working on this project, I was personally shocked when I discovered
that we absolutely NEEDED paper currency in order to set Gold free. Going in,
I was a charter member of the Goldhearts club, and
I emerged even more excited about the prospects of Gold than before.
We need a fiat currency like the euro that structurally supports Freegold in order for gold to perform its highest and
best role in the international monetary and financial system. The alternative
is global economic chaos upon the denouement of the dollar. This is why I
praise the euro.
And here we are today. The U.S. dollar has built up 88 years' or so worth of
global "network value" that is now being challenged by network
operator complacency and conflict of interest, as well as a new competitor
that has eliminated the dollar's two fundamental flaws.
So here's the dilemma. What do you do if your use of the dollar in so many
ways is the most important to the dollar's global network value? If you
abandon it you will be hurt. Yet if you stick with the dollar you will be
hurt badly in the end. So how do you minimize your own cost of switching
currencies?
I have a reading assignment for all of you. It comes courtesy of the ECB and
it should spark a lively discussion in the comments here. Perhaps it will
even help add some network value to this blog.
This is paper #77 from the ECB's "Occasional Paper Series." It is
titled:
OIL MARKET STRUCTURE, NETWORK EFFECTS AND THE CHOICE OF CURRENCY FOR OIL
INVOICING
You can download the paper here:
http://www.ecb.int/pub/pdf/scpops/ecbocp77.pdf
The following excerpts are offered as a teaser and not a substitution for
reading the whole thing. The actual paper is only 16 pages of reading even
though the pdf is 33 pages long. Here are a few
excerpts:
A recurring theme in recent years in the debate on
the international role of currencies has been the possibility of pricing oil
in euro.
The traditional economic literature provides ample reasons why oil is
invoiced in one single currency around the globe. Specifically… the US
dollar.
Despite the strong case for the use of one vehicle currency in the oil trade,
the analysis of this paper suggests that the introduction of a new currency
in the crude oil market is possible.
The country with the largest weight among the oil exporting nations is Saudi
Arabia. It has the world’s largest proven petroleum reserves
(one-quarter of the total) and some of the lowest production costs, and is
the largest producer and net exporter of oil (see Appendix, Table 1). As of
May 2005, owing to the recent rapid increase in demand for petroleum, Saudi
Arabia is the only country with any surplus production capacity: 900-1,400
thousand barrels per day, or some 13% of total capacity (EIA, 2005b). This
enormous capacity has allowed Saudi Arabia to play the role of “swing”
producer.
Until a few years ago, oil earnings were deposited in international banks in
US dollars. However, since 2002, OPEC countries have increasingly deposited
their oil wealth in euro-denominated accounts (12% in the third quarter of
2001, against 25% in the second quarter of 2004) at the expense of US
dollar-denominated accounts (75% in the third quarter of 2001, against 61.5%
in the second quarter of 2004). These observations support the view that the
oil exporting countries, as well as some oil importing countries, such as
those within the euro area or in its vicinity, could potentially be willing
to invoice or settle their oil contracts in euro or in another currency other
than the US dollar. The next section discusses current practices as regards
price setting in the oil market.
Why is crude oil predominantly invoiced in one
currency? The next section attempts to answer this question.
Network effects arise when the utility a consumer derives from a particular
good is dependent upon the number of other individuals also consuming that
good. The network property of a good has the following four implications for
the market for that good. First, a minimum level of agents using the good
(critical mass) is necessary for the initial adoption of a network good. Second,
the demand for network commodities is associated with a bandwagon effect,
i.e. the more individuals use the good, the more
incentive there will be for other individuals to use it as well. Third,
network effects may give rise to multiple and unstable equilibria
related to the interplay of information, expectations and coordination.
Finally, there are two problems linked to network goods, which may result in
market failures: excess inertia, i.e. resistance by individuals to using a
“superior” network commodity, and excess momentum, i.e. a rush by
individuals to an “inferior” network good. Treating money as a
network good is a recent development in economics and has led to interesting
results concerning the origin of money, fiat currency and monetary integration.
This section develops a model that captures network effects in the oil
market, extending the models developed by Stenkula
(2003) and Oomes (2003). The market consists of
many buyers (B) and sellers (S) of crude oil. While the oil producers are sellers
in this game, they have an incentive to invoice their oil contracts in the
currency with which they will pay for their (non-oil) imports of goods and
services from the rest of the world. In short, we will call these (non-oil) goods and services food.
Similarly, the rest of the world are buyers of oil
and sellers of food. Both parties aim to minimize foreign exchange risk and
costs associated with the use of a specific currency for trade. In an
environment where buyers and sellers are matched randomly and are subject to
cash-in-advance constraints, both types of agents may choose between two
currencies, i.e. euro (e) or US dollars (d), as the invoicing currency for
their contracts. Each contract is fully invoiced in a single currency. In
addition, the price of each contract is assumed to be constant and normalised to one. At time t, the sellers sell oil to the
buyers, while at time t + 1, the buyers of oil sell
food to the oil sellers. Hence, all agents try to anticipate the currency
they will need for purchases in the next period.
Depending on whether or not the currency they accept for payment for oil is
the same as the currency they use for their imports, the oil producers (S)
may incur three types of cost, related to the three functions of money
– medium of exchange, unit of account and store of value.14
14 Note that, although for the remainder of the paper we refer to oil
exporting countries, the analysis for oil companies is similar: they are
either buyers or sellers of oil, or both; and they too incur costs when they
invoice oil in one currency and have to record profits and pay taxes and
dividends in another.
The theoretical literature on trade invoicing explains the almost universal
use of the US dollar in international trade in crude oil by means of the fact
that petroleum is a homogeneous good traded in organized exchanges. Apart
from serving as a medium of exchange, the US dollar fulfills the function of
a unit of account by providing price transparency in the oil market. Thirdly,
the macroeconomic stability of the United States and the depth of the US
financial markets explain the role of the US dollar as a store of value and
the low liquidity costs associated with holding the currency.
Please discuss.
Sincerely,
FOFOA
Levon wears his war wound like a crown
He calls his child Jesus
`Cause he likes the name
And he sends him to the finest school in town
Levon, Levon likes his
money
He makes a lot they say
Spends his days counting
In a garage by the motorway
He was born a pauper to a pawn on a Christmas day
When the New York Times said God is dead
And the war's begun
Alvin Tostig has a son today
And he shall be Levon
And he shall be a good man
And he shall be Levon
In tradition with the family plan
And he shall be Levon
And he shall be a good man
He shall be Levon
Levon sells cartoon balloons in town
His family business thrives
Jesus, he blows up balloons all day
Sits on the porch swing watching them fly
And Jesus, he wants to go to Venus
Leaving Levon far behind
Take a balloon and go sailing
While Levon, Levon slowly
dies
He was born a pauper to a pawn on a Christmas day
When the New York Times said God is dead
And the war's begun
Alvin Tostig has a son today
And he shall be Levon
And he shall be a good man
And he shall be Levon
In tradition with the family plan
And he shall be Levon
And he shall be a good man
He shall be Levon
Sincerely,
FOFOA
FOFOA is A
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