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Thursday, September 25, 2008

Why U.S. Dollars Remain So Popular

In Washington, DC it looks like Republicans and Democrats are debating whether to use $700 billion of U.S. taxpayers money to buy up mortgage debt for house loans that have already gone through foreclosure. Many of the actual homes behind the bad mortgages sit empty and decaying in communities all across America. That's what it looks like but if you inspect closer the U.S financial situation appears even more rocky.

That $700 billion is not U.S. taxpayer's money. Tax receipts from 2007 barely cover the interest payments on U.S. debt. That $700 billion really represents more foreign loans. U.S. Treasury Notes will have to be sold to China, Saudi Arabia and other willing buyers to cover more debt. There is some uncertainty about how long foreign nations and rich people will continue to buy U.S. debt.

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U.S. debt does not pay really good interest, in fact after you figure in the losses on exchange rates people that invest in U.S. typically lose money. People that buy the debt of other nations often decide to loan money based on the risk involved. Buying the debt of Mauritania, for example, is quite a bit riskier than buying U.S. debt.

The yield on 10-year Treasury was a little less than 4% on Tuesday. Most nations hold U.S. debt that pays an interest rate of less than 2%. They lose 10% on the exchange rate if they sell those notes. Inflation rates in China run about 6% right now. So China really earns negative 15% interest on U.S. debt. That's pretty poor returns for such big loans.

All those rates would grow even worse if U.S. debt soars higher.

Other countries like to hold reserves in U.S. dollars for the same reason moneychangers from Cairo to New Delhi like buying U.S. $100 notes. There always seem to be available buyers for dollars any time of day, anywhere in the world. Even though the U.S. financial system is a train wreck and U.S. debt is counted in the trillions of dollars, moneychangers still accept $100 bills in exchange for local currency anywhere. They may not give you as much local currency but they will always accept those green pictures of Ben Franklin.

Some moneychangers will accept Euro notes or pounds sterling, the money England uses, but not nearly as many as are willing to accept U.S. currency. This remains true even in places like Pakistan or Iran where people profess to a hatred of the U.S.. The value of the dollar is not really determined by the health of the U.S. economy. It has more to do with the security of the U.S..

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People may have been able to destroy some New York skyscrapers but there will be no foreign armies invading U.S. soil anytime soon. If Russia tried that same stunt they pulled on the Republic of Georgia, by invading Alaska, for example, U.S. forces would come down on Russia like a megaton of bricks. Russian cities would burn before any Russian tanks even reached the outskirts of Anchorage, even before Governor Palin could come up with a witty remark.

This security blanket keeping the dollar warm extends way beyond U.S. shores. U.S. forces guarantee the safety of Saudi Arabia, Taiwan, Korea, Japan and Israel, to name a few places. Even China needs the U.S., if only for the shelves of WalMart stores that stock so many China products. If the Chinese decides to use its $500 billion of U.S. Treasury notes like some kind of economic weapon they would be hurting Asia's economy at the same time.

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So why don't foreign nations keep their reserves in Euros? The value of Euro notes depends on the stability of the European Union. The EU, especially after a recent vote in Ireland, looks about as stable as sandcastle. If the Euro notes keep soaring in value against the dollar the countries that make up that Union will not be able selling their wares, even in other parts of Europe much less Asia or the Americas.

Moneychangers in market places around the world only know that the dollar is here to stay. They only know that every other moneychanger is always ready to accept dollars. They also know that the U.S. military is ready to defend all those places where the U.S. does plenty of business so the dollar is here to stay, for now. It will probably be decades before that situation changes in any significant way.

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Links:

Washington Post article
New York Times article

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