Traditional monetary policy attempts to revive flagging economies by cutting interest rates. However, a continued decline in economic activity, coupled with a seizure in intra-bank and bank lending, has forced central bankers to adopt more extreme measures.
In most cases, this led to blanket guarantees on bank deposits and recapitalisation of financial institutions through government-purchase of toxic assets. Nevertheless, these approaches have not proved entirely effective and have forced policy makers to adopt measures last used by Japan during the ‘lost decade’ of the 1990s.
The policy instrument in question is ‘quantitative easing’. It involves stimulating the economy by injecting liquidity into the financial sector, despite interest rates already being at, or close to, zero. Quantitative easing advocates the creation of money out of thin air, either electronically or physically, via the printing press. With this new money, central banks are able to infuse additional liquidity into the financial sector through the purchase of financial assets, including government and corporate bonds, equities and even mortgages.
The aim of this process is to increase the primary reserves of afinancial institutions whilst reducing risk on the balance sheet. Quantitative easing can therefore increase tier one capital and allow for the creation of more loans far in excess of the initial capital injection.
Likewise, the mass purchase of bonds induces institutions and investors to introduce extra capital into the economy. The primary goal is to get banking institutions lending to consumers and business again which will stimulate the economy.
With such an extreme widening of the monetary base comes the serious danger of inflation, or even hyperinflation. As such, these risks have brought into question the benefits of quantitative easing as a monetary policy instrument and have caused many inflation-fearing central banks to abstain from its use e.g. the ECB. The main proponents of quantitative easing are currently the United States Federal Reserve and the Bank of England.
For these two economies, the expansion of the money supply has proven reasonably successful in the recapitalisation of the banks and the stimulation of economic growth. Moreover, the weakening of the dollar has given rise to a major improvement in the US balance of trade with imports declining and exports increasing considerably. This has also occurred in Britain, although not to the same extent.
This decline in the dollar and sterling relative to other currencies, particularly the euro, has increased the costs of imports and amplified inflationary pressures within both economies, while fears over the future value of the dollar have been demonstrated in increasing gold prices which traditionally move in line with US inflation.
As such, the reputation of the dollar as the world’s reserve currency and primary unit of international trade has been put at stake. China, Russia, OPEC, Japan, and even France are rumoured to be calling for a move from the dollar as the unit in which oil is priced and sold in favour of a basket of international currencies. This proposition would have serious ramification on the value of the US dollar, as a major increase in supply brought about by a global move away from its use would essentially destroy its value.
Nevertheless, the fact that the dollar is the primary unit of currency reserve serves to support the notion that Russia – and China in particular which holds over $2trillion worth of currency and government bonds – cannot afford to devalue the dollar as the potential impact which this may cause to their reserves could devastate their respective economies.
This suggests that the noises being made about a move away from the dollar are aimed more at encouraging the US Federal Reserve to adopt more prudent monetary policy than at actually introduce a new global unit of exchange.
The general consensus in recent weeks and months therefore, has not necessarily been concerned with the fate of the dollar as a global reserve currency, but rather with what extent fears of future inflationary pressures will impact the value of gold, oil and the relative price of the dollar itself.