Daniel Gross’s article on the currency preferences of the world’s underworld is too good not to link to. It seems like the world’s drug lords are less willing than the People’s Bank of China to finance the US on the cheap. Indeed, some may even be joining Warren Buffet and no doubt George Soros and others in betting againt the dollar. Thanks to General Glut for the link.In 2002, I briefly worked on the balance payments of an Eastern European country. Even back then, Eastern Europeans were starting to shift from “dollars under the mattress” to “euros in the domestic banking system.” What prompted the shift? First, the dollar had stopped rising v. the Euro (and v. most Eastern European currencies), and was starting to fall. Up until that point, the dollars under the mattress had delivered a solid return: their local purchasing power rose along with the dollar. Second, euro notes were starting to circulate widely. Confidence has many sources. A virtual ecu (the euro’s antecedent, the european currency unit; also, an old french currency) is not that different from an euro denominated bank account (a few lines on the bank’s computer system). But the ability to turn virtual euros in the bank into physical euro notes mattered.

This process — reverse currency substitution — was generating substantial capital inflows into Eastern Europe. A dollar (cash) is an external financial asset, a domestic euro denominated bank account is a domestic financial asset. In effect, Eastern Europeans were running down their external savings (their hoards of dollars), and in the process financing either current account deficits or central bank reserve accumulation.

A similar process has been an important source of financing for Turkey this year. Why hold dollars cash, of even dollar denominated bank accounts, when you can earn much higher rates on a Turkish lira bank account? The dollar’s purchasing power in Turkey has been falling since Turkey started to recover from its 2001 crisis. So long as long as the new Turkish lira tracks the euro, not the dollar, Turkish citizens will earn far more lending a(new) lira to the Turkish government than holding a stack of 100 dollar bills.

Alas, this is not necessarily the most stable way to finance a current account deficit — and Turkey is one of the few countries other than the US running a large current account deficit.