The Triffin Dilemma

In reference to my previous post concerning the euro crisis and the US dollar, I thought it might be a good idea to post some snippets from my book which are dealing with the Triffin dilemma. So here goes:

[book excerpt]

How the war led to the crisis, and how the crisis financed the war

In 1959 Robert Triffin had already discovered a major flaw in the construction of the international financial system: the special role of the US-dollar being used as the world reserve currency. Triffin predicted that – due to the world wide demand for US-Dollar – the US would have to accumulate ever increasing debts with the rest of the world, until this systemic tilt of the international financial system would finally have to result in a crisis.

Aggravated by insufficient bank supervision, lacking financial standards and dubious financial instruments, that hunger for US-Dollar as described by Triffin was misused for profit maximization and resulted in a monumental increase of power of the financial industry.

The financial system tilted even further as the US Federal Reserve System kept lowering the federal funds rate – as a reaction to the terrorist attacks of 9/11 and the resulting fear of more terrorist attacks and a pending war against Iraq. By doing so, the Fed knowingly fueled the ballooning real estate bubble, thereby causing an inflow of funds into the US – funds, which in these times of war were needed by the US-administration.

The US received mortgage loans from all over the world, amounting to a approximately 20% of the world gross national product. Only at first sight were they used for the construction or purchase of real estate. De facto, they financed the US trade deficit and with it, the Iraq war.

But the US interest rate policy was based on a massive miscalculation: the Iraq war was planned to be very cost-effective and to last about two and a half months only. Far from it! Today, the conflict is going into its sixth year, in the history of the US only WW II was more expansive than the war in Iraq (the estimated costs of which are 2700 Billion US Dollar, or around 400 US Dollar for every person on Earth)

And so, 50 years after Triffin’s prognosis, his words have come true in form of the subprime mortgage crisis: The USA accumulated debts with the rest of the world of such magnitude that they are unable to settle. The international financial system now needs to be rethought in its very foundations.


The special role of the USA

Two further questions need to be addressed: How could the housing bubble grow to such enormous proportions encompassing the whole world? And why did this crisis have its origin in the USA and not in Australia, Austria or any other country?

The size of the bubble is mostly attributed to the boundless greed of investors and the global interconnectedness of financial markets highly lacking in transparency. Certainly, these factors have contributed to the size of the bubble, but why did these forces have their strongest effect in the US?

The bubble’s origin in the US, its global propagation and its size have one common and fundamental cause: the special role of the US-Dollar as world key currency. This special role results in two surprising and far-reaching consequences:

  1. The USA is living beyond its means: in order to supply the amounts of US-Dollars which are needed by world trade, the US has to spend more money abroad than it earns.
  2. The world is investing huge sums in the US: in order to stay liquid in US-dollars, reserves are preferably held in US financial papers (bonds, stocks etc.).

Since 1959, the first of these two special features is known as the “Triffin dilemma” – being caused by the following irresolvable contradiction:

  • The national currency which is being used as world key currency has to be safe and stable. Therefore, the economy of that reserve nation must be stable.
  • Being used as world key currency, the reserve currency must be available in very large amounts outside of the boundaries of its nation. Therefore, the reserve nation must spend more money than it is earning.

But how could – in the long run – the economy of a nation be stable and exhibit large trade deficits at the same time? This problem is aggravated by the fact, that the trade deficit of the reserve nation has to grow in order to provide an increasing money supply to a growing world economy. While the reserve nation is building ever bigger deficits, the trust in its currency will fade accordingly – until this mechanism culminates in a full blown crisis of confidence in that reserve currency. Therefore, Triffin concluded:

The use of national currencies as international reserves constitutes indeed a „built-in destabilizer“ in the world monetary system.*)

In the preface to his book, written on Halloween 1959, Triffin closes with the not so optimistic words:

Whether […] these problems have any chance to be negotiated in time to avoid a major crisis in the international monetary system, is an entirely different matter which history alone can, and will, answer.**)

In March 2009 Zhou Xiaochuan, governor of the People’s Bank of China, in a widely acclaimed speech called for a reform of the international monetary system. In his speech he expressed his conviction that the Triffin dilemma was the underlying cause of the crisis and its global propagation:

The outbreak of the crisis and its spillover to the entire world reflect the inherent vulnerabilities and systemic risks in the existing international monetary system. […] The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. […] Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws.***)

The second special feature of the USA results from the fact that – due to the special role of the US dollar as key currency – the USA attracts more foreign investments than any other country in the world; in the current monetary system it is almost mechanically codified, that the nations of the world invest their money in the USA. Since the most important commodities and markets of the world are using the US-dollar as transaction currency, market participants and central banks are forced to keep gigantic amounts of reserves in US dollars, in order to be prepared for fluctuations in trade as well as in currencies exchange rates. Obviously, since the storage of cash does not earn any interest, these reserves are not held in the form of US-dollar bank notes but in the form of interest earning US bonds ****) which therefore need to be bought in accordingly large quantities. When for example China, through the export of t-shirts to the US, would generate a surplus of US-dollars, then these dollars would in the first instance lie about, not earning interest while losing purchasing power due to inflation. In order for this not to happen, China will loan its excessive dollars back to the US, who then can use these dollars to buy more t-shirts from China. Having earned the very same dollars now a second time, China lends them back to the US, who again can buy more t-shirts. And so on and so forth. The US is buying t-shirts, while China is buying US bonds.

Since all of the world is lending their money back to the US in that manner, in the course of time the US regressed from the wealthiest nation in the world to the most indebted of them all. Nobel laureate Joseph E. Stiglitz explains:

From this perspective, the continuing trade deficit of the US has to be attributed to the fact that the US-dollar is a reserve currency: other nations are unswervingly stockpiling US treasury bills.*****)

The growing global demand for US-American financial products resulted in the US developing from a nation that was exporting goods into a nation that now is exporting financial products. Accordingly, the share of the goods-producing sector within the US-American economic performance has dropped, while the share of the financial sector has increased dramatically (Fig. 28), resulting in a correspondent increase of size and power of the US financial industry. Over the course of the last decades the political influence of the financial industry has grown to proportions that urged former IMF chief economist Simon Johnson to publish his remarkable article The Quiet Coup in which he describes the situation as a factual take-over of the US government by the financial industry, comparing the political circumstances in the US to those of a banana republic.******)


Fig. 28: Financial-industry profits as a share of US business profits.*******)


*) Triffin, Robert, 1961, Gold and the dollar crisis. The future of convertibility. New Haven and London: Yale University Press, 87.
**) Triffin, Robert, 1961, Gold and the dollar crisis. The future of convertibility. New Haven and London: Yale University Press, ix.
***) Xiaochuan, Zhou 23.03.2009 Reform the International Monetary System, The People‘s Bank of China, 23.04.2009
****) most typically in US treasury notes, also referred to as treasury-bills
*****) Author’s translation “Nach dieser Sichtweise ist das anhaltende Handelsbilanzdefizit der USA auf die Tatsache zurückzuführen, dass der US-Dollar eine Reservewährung ist: Andere Staaten horten unentwegt US-Schatzwechsel.” Joseph E. Stieglitz, Die Chancen der Globalisierung. Berlin: Siedler Verlag 2006, 316.
******) Johnson, Simon, 2009, The Quiet Coup in: The Atlantic Online, 21.04.2009
*******) Johnson, Simon, 2009, The Quiet Coup in: The Atlantic Online, 21.04.2009

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