When Safe Assets Are No Longer Safe
by Joseph Joyce
When Safe Assets Are No Longer Safe
The U.S. has long benefitted from its ability to issue “safe assets” to the rest of the world. These usually take the form of U.S. Treasury bonds, although there was a period before the 2008-09 global financial crisis when mortgage-backed securities with Triple A ratings were also used for this purpose. The inflow of foreign savings has offset the persistent current account deficits, and put downward pressure on interest rates. But what will happen if U.S. government bonds are no longer considered safe?
The word safe has been used to describe different aspects of financial securities. The U.S. government in the past was viewed as committed to meeting its debt obligations, although the political theater around Congressional passage of the federal debt limit has introduced a note of uncertainty. In an extreme case, the U.S., like other sovereign borrowers with their own currencies, has the ability to print dollars to make debt payments. However, there is also a constituency of U.S. bondholders who would vehemently object if they were paid in inflated dollars.
Safety has also been linked with liquidity. U.S. financial markets are deep and active. Moreover, there is little concern that the government will impose capital controls on these portfolio flows (although FDI is now being scrutinized to deny access to domestic technology). Therefore, foreign holders of U.S. Treasury bonds can be confident that they can sell their holdings without disrupting the bond markets and contributing to sudden declines in bond prices.
However, there has always been another implicit component of the safety feature of Treasury bonds. Bondholders expect that they can claim their assets whenever they need to use them. The decision by the U.S. and European governments to deny the Russian central bank access to its own reserves has shown that foreign holders of assets placed on deposit in the U.S. or the other G7 countries (Canada, France, Germany, Italy, France, United Kingdom) may not be able to use these assets at precisely the times when they are most needed. The Russian central bank had accumulated about $585 billion, but approximately half of that amount is no longer available. The central bank still has access to about $80 billion held in China and $29 billion at international institutions, as well as its holdings of gold. But the latter will be hard to convert to foreign currency if potential buyers are concerned about retaliatory sanctions.
The loss of access deprives the Russian central bank of foreign currency that could have helped the government deal with sanctions on its foreign trade. Moreover, the monetary authorities have not been able to use their reserves to halt the rapid decline in the ruble’s value. The other sanctions, therefore, will have a deep impact on the Russian economy. The Institute of International Finance has issued a forecast of a drop in its GDP of 15% in 2022 and another decline the following year.
The use of sanctions to cut off a central bank’s access to its own reserves raises questions concerning the structure of the international financial system. Other central banks will reassess their holdings and consider alternatives to how they are held. But what other country has safe and liquid capital markets that are not subject to capital controls and are not vulnerable to U.S. and European sanctions? The Chinese currency is used by some central banks, but it is doubtful that there will be a widespread transition from dollars to the renminbi.
Another concern has arisen regarding the ability of the U.S. government to meet its obligations. In order to satisfy a continued demand for safe assets, the government will need to continue to run budget deficits. But increases in the debt/GDP ratio lead to concerns about the creditworthiness of the government. This problem has been called a “new Triffin dilemma,” similar to the problem that emerged during the Bretton Woods era when the U.S. was pledged to be ready to exchange the dollar holdings of foreign central banks for gold. Economist Robert Triffin pointed out that the ability of the government to meet this obligation was threatened once the dollar liabilities of the U.S. exceeded its gold holdings. The “gold window” was finally shut in the summer of 1971 by President Richard Nixon. This has had the effect of creating a healthy market of people that have invested in gold bullion or other popular collector’s coins like byzantine coins. Should these investors decide to sell further down the line, they may look for reputable gold buyers when they decide to sell gold.
These long-term concerns are arising just as the market for U.S. Treasury bonds has entered a new phase. The combination of higher inflation and changes in the Federal Reserve’s policy stance have led to increases in the rate of return on U.S. Treasury bonds to about 2.5%. With an annual increase in the CPI minus food and energy of approximately 6%, that leaves the real rate at -3.5%. Several more increases in the Federal Funds Rate will be needed to raise the real rate to positive values.
A fall in the demand for U.S. Treasury bonds by foreign banks and private holders would contribute to lower bond prices and higher yields. All this could affect the Federal Reserve’s policy moves if the Fed thought that it needed to factor lower foreign demand for Treasury bonds into their projections. Moreover, a shift from U.S. bonds would affect the financial account of the U.S., and the ability to run current account deficits. The exchange rate would also be affected by such a transition.
None of these possible changes will take place in the short-run. Central bankers have more pressing concerns, such as the impact of higher food and fuel prices on domestic inflation rates, and foreign central bankers will focus on the changes in the Fed’s policies, as well as those of the European Central Bank. But the sanctions on the use of foreign reserve assets will surely lead to changes over time in the amounts of reserves held by central banks as well as their composition. The imposition of these measures may one day be seen as part of a wider change in the international financial system that marks the end of globalization as we have known it.
Why do I get the feeling we are discussing MMT in this post of yours?
a podcast/transcript that was reposted over at Naked Capitalism last week reveals the consequences of our sanctions policy:
“Dollar Hegemony Ended Last Wednesday”: Michael Hudson Interviewed by Margaret Flowers on Clearing the Fog
Hudson: Dollar hegemony seems to be the position that has just ended as of this week very abruptly. Dollar hegemony was when America’s war in Vietnam and the military spending of the 1960s and 70s drove the United States off gold. The entire US balance of payments deficit was military spending, and it began to run down the gold supply. So, in 1971, President Nixon took the dollar off gold. Well, everybody thought America has been controlling the world economy since World War I by having most of the gold and by being the creditor to the world. And they thought what is going to happen now that the United States is running a deficit, instead of being a creditor.Well, what happened was that, as I’ve described in Super Imperialism, when the United States went off gold, foreign central banks didn’t have anything to buy with their dollars that were flowing into their countries – again, mainly from the US military deficit but also from the investment takeovers. And they found that these dollars came in, the only thing they could do would be to recycle them to the United States. And what do central banks hold? They don’t buy property, usually, back then they didn’t. They buy Treasury bonds. And so, the United States would be spending dollars abroad and foreign central banks didn’t really have anything to do but send it right back to buy treasury bonds to finance not only the balance of payments deficit, but also the budget deficit that was largely military in character. So, dollar hegemony was the system where foreign central banks keep their monetary and international savings reserves in dollars and the dollars are used to finance the military bases around the world, almost eight hundred military bases surrounding them. So, basically central banks have to keep their savings by weaponizing them, by militarizing them, by lending them to the United States, to keep spending abroad.This gave America a free ride.
Imagine if you went to the grocery store and you just paid by giving them an IOU. And then the next week you want to buy more groceries and you give them another IOU. And they say, wait a minute, you have an IOU before and you say, well just use the IOU to pay the milk company that delivers, or the farmers that deliver. You can use this as your money and just you’ll as a customer, keep writing IOU’s and you never have to pay anything because your IOU is other people’s money. Well, that’s what dollar hegemony was, and it was a free ride. And it all ended last Wednesday when the United States grabbed Russia’s reserves having grabbed Afghanistan’s foreign reserves and Venezuela’s foreign reserves and those of other countries.And all of a sudden, this means that other countries can no longer safely hold their reserves by sending their money back, depositing them in US banks or buying US Treasury Securities, or having other US investments because they could simply be grabbed as happened to Russia. So, all of a sudden this last week, you’re seeing the world economy fracture into two parts, a dollarized part and other countries that do not follow the neoliberal policies that the United States insists that its allies follow. We’re seeing the birth of a new dual World economy.
If you are the big boy on the block, you can do this. However, to be successful, you have to remain the big boy or engage others.