Oct 23, 2008

Today, we're all Keynesians. What if we all are?

Adam Smith used to be the dominant economist, promulgating his notion of the invisible free hand of the markets that set supply and demand at equilibrium. Then along came Keynes who said that the government should engage in extra spending during recessions because markets take too long to correct on their own.

Today, we are faced with the possibility of a global recession and countries are trying to navigate their way through it. Unlike past crises, the US dollar is no longer the absolute reserve currency of the world. Other countries have built up substantial foreign reserves over the past two decades, as demonstrated in this graph (2008 data point is as of March):

The graph begins in 1979 since that is when Deng Xiaoping began his program of the four modernizations. As of September 2008, China's foreign reserves were reported at $1.9T, with an estimated 70% of that being held in US dollar denominated assets such as treasuries. This balance has accumulated over the years as China has bought dollars and sold yuan to keep their currency undervalued which makes their exports more competitive. However, now that economic growth is slowing, it is possible that China will take a page from the Keynesian playbook and use sell their reserves to generate yuan, which would then be spent in their local economy. This plan could have an enormous effect on the dollar - can you imagine what the exchange rate would be if $1.3T of treasuries were sold? Even if the liquidation was conducted in an orderly fashion, it could easily lead to a crash in the value of the dollar.

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