World's No.1 Market Overhang

Brad DeLong reports on a Federal Reserve research paper by Matthew Higgins and Thomas Klitgaard on the way world central banks have been building up foreign exchange reserves. Up to this year, the total holdings of foreign currency assets in central banks have almost doubled since 1995. Now, there are a couple of obvious market moving factors. One is the traumatic experience of the mid-90s financial crises. Another has been the Japanese struggle to keep the yen from appreciating. A factor some years ago was a major switch from gold to currencies and securities (remember Gordon Brown selling off 300 tonnes of the stuff?), driven by the falling price of gold. With the gold surge of the last few years, this one has had its day. The big story, though, has been the combination of the US trade deficit and the various Asian currencies' links to the dollar.

This has caused heavy Asian central bank intervention to support the dollar, effectively recycling the outflow of greenbacks into US assets. This led to the second linkage, between the intervention and the US government budget. Now, the most economic way of holding dollar reserves is to buy US Government debt, treasury bills. This is because they pay interest but can be liquidated at any time. So, the central bank intervention ends up by financing the US government deficit. Higgins and Klitgaard:

"Indeed, data from the Bank for International Settlements show that at end-2003, central bank holdings of dollar assets, at roughly $2.1 trillion, were equivalent to more than half of marketable Treasury debt outstanding.


According to the authors, the central bank reserve purchases have compensated for a decline in foreign private purchases of U.S. assets. "Continued large U.S. current account deficits," Higgins and Klitgaard suggest, "raise the risk that foreign investors could eventually require some combination of lower U.S. asset prices, higher U.S. interest rates, and a weaker dollar as compensation for adding to their stock of claims on the United States.""

Now that is a polite way of saying that the plug could be pulled. What is happening is a frequent phenomenon in economics, where a particular situation is apparently stable although the market should theoretically adjust - until it happens. You might even call it a Keynesian sticky price. These days, it's more fashionable to talk about a "tipping point", but the idea is much the same. In fact, that's another frequent economic phenomenon - different and mutually hostile schools of thought whose theories explain the same phenomenon in much the same way. As well as a Keynes version of this, and a tipping point one, you could also see it in terms of games theory - neither actor in the game has an alternative strategy offering a better outcome, so neither will make a first move. If the Asian central banks pull their support, their current trade advantage will go, and they are also sitting on a huge pile of dollars that will lose value. If the US decides to let it slide, they lose out. So - no movement.

By the way, we should be wary of gloating in the event of a rapid devaluation of the dollar. If the dollar drops we - sterling and the eurozone - go up, with obvious consequences for exporters. Due to the fix between east Asia and the US, we've already experienced some of this. That would stop, but would probably be outweighed by the big story. Competitive devaluations? God, how 30s...