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China ....and the Dollar


Source : http://online.wsj.com

Markets don't like Treasury talking down the dollar's status.

As if the dollar didn't have enough problems, Timothy Geithner took China's bait yesterday and said he was "quite open" to its suggestion this week to displace the greenback with an "international reserve currency." The dollar promptly fell and stocks followed, before the Treasury Secretary re-emerged to say "the dollar remains the world's dominant reserve currency. I think that's likely to continue for a long time."

Mr. Geithner is learning on the job, and yesterday's lesson is that it isn't smart to fool with currency markets when you are already tempting fate with a gigantic U.S. reflation. Treasury and the Federal Reserve are flooding the world with dollars to break the recession, and the world is rightly getting nervous. The solution floated by Chinese central bank governor Zhou Xiaochuan -- an increased role for the International Monetary Fund -- isn't desirable. But his warning about the dangers of dollar weakness and exchange-rate instability is still worth heeding.

Since the collapse of Bretton Woods in 1971, the global economy has tried to function with floating exchange rates, in which the "market" is said to set currency prices. As the world discovered in the 1970s and the Bush Treasury forgot, however, the market for currencies isn't the same as for apples or copper. Central banks control the supply of currencies through their monopoly on money creation. Often, as at the Alan Greenspan-Ben Bernanke-Donald Kohn Federal Reserve this decade, they get policy wrong, with disastrous consequences. Amid the global economic downturn, some central banks, like Vietnam's, are also turning to currency devaluation for a trade advantage.

Mr. Zhou may want to head off this potential train wreck. On Monday he proposed an international reserve currency "anchored to a stable benchmark and issued according to a clear set of rules." He wants the supply of money to allow for "timely adjustment" to "changing demand," and those adjustments to be "disconnected from economic conditions and sovereign interests of any single country." And he thinks the IMF can create a global currency by expanding the use of its already-existing Special Drawing Rights (SDRs), a synthetic currency linked to the underlying currencies of IMF states.

Yet who would determine the "right price" of the SDR -- the IMF? The multilateral institution's economic prescriptions have sent numerous nations into tailspins, particularly in Asia. There's nothing to say, too, that national monetary authorities wouldn't cheat and adjust their domestic money supplies as they saw fit -- or apply political pressure on the IMF to change the SDR's currency weightings in their favor.

But the main problem with the SDR is that it can't be used for anything in the real world. When the IMF allocates SDRs, recipient countries exchange them for local currencies at local central banks. That money is then used to buy real assets and facilitate trade. That exchange inflates the money supply of the domestic country that's accepting the SDRs in exchange for local currency.

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