I liked Summers’ Brookings piece, including the Dornbusch quote “things take longer to happen than you think they will and then they happen faster than you thought they could.” Perhaps this applies to international adjustment. Also – “economic policy making is about balancing risks”, and “recent events … the greatest failure of risk management in financial history.” I think he’s dead on re the necessity of taking credit spreads into account in interpreting the current setting of monetary policy – certainly not a view held by everybody. Considerable wisdom on the stuff of risk overall – he must have been interesting to work with.

Of course pegging is not the same as dollarization, if you factor in the possibility that the peg can break. This is what happened to Argentina. Their currency board was never a real currency board. The central bank guaranteed more pesos than it had dollars to back them. Similarly, CBs in the 1930s saw their peg to gold fail for just the same reason.

Needless to say, the RMB, being undervalued rather than overvalued, is not at risk for an Argentina style event. At least not at present.

Consistent with this, dollarization is not the same as pegging:

“There are some substantial drawbacks to adopting a foreign currency. When a country gives up the option to print its own money, it loses its ability to directly influence its economy, including its right to administer monetary policy and any form of exchange rate regime.

The central bank loses its ability to collect ‘seigniorage’, the profit gained from issuing coinage (the minting of monies costs less than the actual value of the coinage). Instead, the U.S. Federal Reserve collects the seigniorage, and the local government and gross domestic product (GDP) as a whole thus suffer a loss of income.

In a fully dollarized economy, the central bank also loses its role as the lender of last resort for its banking system. While it may still be able to provide short-term emergency funds from held reserves to banks in distress, it would not necessarily be able to provide enough funds to cover the withdrawals in the case of a run on deposits.

Thanks for providing a very useful analysis. Using Libor as a proxy of demand for private sector finance illuminates your pictures, as Libor adjusts rapidly to changes in risk appetite and relative currency preferences. Libor is staying stubbornly high, although down a touch with the massive injections of central bank liquidity.

If you overlaid dollar base rate and Libor on your first chart, I think you would see clearly that private sector inflows collapse with Fed base rate cuts and a corresponding spike in Libor would track the reduced inflows.

If Libor should begin seriously falling in 2008, then we could see an appreciation of the dollar and an increase in private inflows. Until then, central banks will have to take the losses of negative risk adjusted interest rates for financing US deficits.

Not that MZM is a terribly good indicator either. There is no qualitative line to be drawn between money of zero maturity, money of one-hour maturity, money of 30-day maturity, etc. In fact, in a world where short-maturity liabilities can be backed by long-maturity assets, it’s arguable that maturity of dollar claims is irrelevant. The assumption that maturity transformation is limited to traditional checking-deposit structures is also, obviously, inoperative. The point is just that the number of claims to dollars is increasing at a fairly considerable clip, and this number is certainly not limited in any way by M0.

I disagree with you about pegging versus dollarization. Some exporter makes a knicknack and sells it to the US for $1. The PBoC prints 7.5 yuan to buy the $1, then uses the $1 to buy a US bond, returning the marbles as Rueff used to say. The 7.5 yuan are spent on noodles.

Clearly if the 7.5 yuan was one renminbuck or RM$, with a 1:1 peg, this would just be a renaming and redenomination of the currency. My point is that, if the Fed accepted RM$ to buy Treasury bonds, and the noodle vendor accepted US$ to buy noodles, we could duplicate the same transaction as:

PBoC issues one RM$ to buy Treasury bonds.
Vendor spends one US$ on noodles.

So these transactions are completely delinked, and we see the net effect of the transaction: the PBoC has created one new RM$ to buy Treasury bonds. Ergo, if the PBoC ever decides to stop with this, the Fed can maintain continuity by picking up where it left off.

My point is that if the peg was a perfect peg, ignoring crawls, capital controls, etc, the US and China would by definition be a single currency area. Call its currency the PD, Pacific dollar. Within this area, you would see large numbers of PDs printed in China and lent to the US.

In this case, does it matter at all where the PD printer is? Not at all. The PDs first appear in the hands of the US borrowers. We see more dramatic rises in consumer prices in China not because the PDs are being printed there, but because they are ending up there. They are ending up there because China’s productive economy is healthy and expanding, and the US’s is a massive rustbucket. If it was the Fed, not the PBoC, which printed PDs and exchanged them for reserves, the new PDs would still be spent on the same Chinese knicknacks and end up in China.

So in a sense, yes, the US is “exporting inflation” and China is importing it. But this loop happens because China, by plugging itself into the USD at an undervalued rate, both makes itself part of the dollar area, and compels itself to mint new USD-equivalent instruments to defend the peg. It is the dollar area as a whole that is experiencing monetary expansion.

Of course China is not the only player in this game. So, for example, if China were to adjust its peg to a market rate, it would still be “importing inflation” generated by other EM CBs in the BW2 game. Furthermore, even if the number of PDs on the planet was constant, the success of Chinese industry might still cause PDs to flow into China, driving up the bid for noodles in Shanghai.

This is why the word “inflation” is so confusing. Inflation is a political indicator. As a consumer, when you see price rises, it is often correct to conclude that you are competing with a counterfeiter, alchemist, helicopter, or other source of new money. If this is the case your wallet has been silently diluted, and you are right to be angry. But it could just be that money that already existed has flowed, for some nonmonetary reason, in the direction of buyers who are bidding in the same markets as you. While this remains undesirable, it does not mean you are being unfairly treated.

that is a very useful exercise. but imagine a world in which each country or currency block printed two currencies – the local currency unilaterally, and the reserve currency by global agreement.

or suppose the chinese issued pegged yuan, say ‘yuandollars’, and also appreciating / depreciating yuan. how would it work, and under what policy regime, and if it couldn’t work – why not ?
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Dollarizing and pegging are very different. The Fed and Congress don’t in fact sponsor the Chinese currency. So China’s money supply is quite separate in terms of gauging its direct effect on US inflation. China is not printing money to buy bonds. It is printing money precisely because its private sector won’t buy bonds. The money it prints is used for anything but buying bonds. That’s why it’s inflationary to the Chinese economy. The domestic Chinese monetary effect of maintaining the peg channels unique inflationary impulses into the domestic Chinese economy, away from the US, while channelling opposite disinflationary impulses into the US economy. Dollars are not being printed in China to buy US bonds – the dollars that buy bonds are sourced from the US – with 0 Chinese involvement in the dollar printing press.

Because you don’t really mean the “value” of these assets. You mean their price in 0-risk money. The more 0-risk money, the higher buyers can afford to bid.

SWFs don’t print new US dollars. That’s why the Fed should be fine with it. The Fed monetary base has been flat for years. China’s has erupted.

Measuring zero-maturity money is an tricky task in a financial system that can transform maturities, but I find “flat” a strong description of this curve. Of course your point that China’s eruption exceeds it is true.

SWFs do not print anything. BW2 CBs print new instruments whose exchange rate to the dollar is fixed and drifting upward.

Imagine a world in which the Fed actually authorized the PBoC to issue its own dollars. Instead of printing yuan to buy dollars, it could print dollars – identical to the American bills, except for a small “made in China” stamp – to buy dollars. Instead of the PBoC defending the peg, Congress could simply make these China dollars legal tender.

If we disregard any crawl in the peg and assume it is fixed permanently for good, dollarizing China does not change the behavior of any economic actor. But it also shows us a bizarre reality in which dollars are being printed to buy dollar bonds. (Or, at least, this reality is economically bizarre. Historically it is actually quite common.)

It is interesting to compare the monetary strains in this dollar-zone to similar strains in the eurozone. The relationship between China and the US, for example, has some resemblance to the relationship between Germany and Spain. Goldilocks for one is boiling the other. If this isn’t “decoupling,” what is it?