Ah, the “dollar trap”.
How can the US protect itself from China’s mass holdings of dollar-denominated securities, which it can dispose of at any time, if it wants to.
From the other perspective, how can China protect itself from a US incentive to inflate itself out of debt, a fact that could see its reserves dwindle in value?
Domingo Cavallo, Chairman of DFC Associates and President of Acción por la República, and Joaquín Cottani, Director at LECG have drafted an interesting proposal on the matter on the VoxEU.org site on Tuesday. They suggest the solution could be as simple as swapping all those securities for inflation-adjusted investments. As they explain:Fortunately, there is an easier and better way to protect the value of emerging market reserves while reducing the risk of a resurgence in world inflation. This is to reduce the incentive of the US government to “inflate its way out of debt.” For this to happen, all US creditors need to do is demand that the US government swap nominal US Treasury bills, notes, and bonds for inflation-adjusted instruments (TIPS) on demand. Since, at present, the supply of TIPS is very small in relation to the rest of the US national debt, bilateral coordination would be necessary to avoid distorting their value.
And according to the authors, readjusting securities for inflation doesn’t have to be hard, namely because it could all happen on a bilateral basis. They explain:This not only makes it easy to implement, but also gives the US government leverage to extract concessions from the other governments. For example, in the case of China, it would be possible for the US to negotiate a quid-pro-quo, whereby China commits to reforms geared to reducing its structural current account surplus—including, but not limited to, a more flexible exchange rate policy. For this reason, it would be preferable that the swap proposal comes from the US rather than from its creditors.
The practical advantages of such a move, meanwhile, would also have a beneficial long-term effect in averting the risk of global inflation, say the authors. Furthermore, by substituting TIPS for nominal bonds, the message from the US government would be loud and clear: it is not planning “to inflate its way out of debt”, a fear factor that may already be feeding its way through to long-term Treasury yields.
Of course, the above contradicts the other widely held position — that inflation is actually the perfect solution to the current quagmire, a view taken by, among others, Ken Rogoff, former chief economist of the IMF. As he wrote in the Guardian in December:
It is time for the world’s major central banks to acknowledge that a sudden burst of moderate inflation would be extremely helpful in unwinding today’s epic debt morass…
…in addition to tempering debt problems, a short burst of moderate inflation would reduce the real (inflation-adjusted) value of residential real estate, making it easier for that market to stabilise. Absent significant inflation, nominal house prices probably need to fall another 15% in the US, and more in Spain, the UK and many other countries. If inflation rises, nominal house prices don’t need to fall as much.
Rogoff is essentially saying that by increasing inflation the US can solve two problems at once – erode the value of its national debt at the same time as reducing the real value of its institutional and other corporate debt, which in turn would cut back the need for explicit haircuts or public bailouts.
But, aside from the reputational issue, there is one major problem with this proposition, note Cavallo and Cottani — the risk that once the inflation genie is out of its bottle, it could be very difficult to put back in. With TIPS, however, there would be no such risk.
Related links:
Don’t forget, inflation is our friend - FT Alphaville
A commodity anchor, or oil as money – FT Alphaville
Is a global super-currency on the agenda? – FT Alphaville