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US dollars once bought mansions, now hovels
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Lack of supervision is largely to blame for the United States' subprime mortgage crisis that later triggered the global economic crisis.

The question remains how the US could be so negligent in supervision, given its experience in the Great Recession in 1930s and given the acknowledged risk of financial derivatives.

The reason, says economist Fan Gang, lies in the de facto dollar standard currency system "that enabled the US to shift a large part of its financial risks to countries all over the world with the latter holding large amounts of dollar assets."

Fan is member of Monetary Policy Committee of the central bank and director of National Economic Research Institute, China Reform Foundation.

"With countries all over the world sharing its financial risks, the US could feel much less risks than it actually caused," Fan said in his speech at the Shanghai National Accounting Institute on April 11.

He gave an example.

Issuing money usually causes inflation. However, the US has been issuing dollars over the years without causing high inflation within the country.

The fact is that with the widespread use of dollars throughout the world, the currency actually caused the inflation in many countries outside the US.

In another example, a country with over three years' huge trade deficit would usually face an international payment crisis, as no other countries would be willing to lend money to a country so mired in international debt for so many successive years.

Accordingly, the country would suffer a big outflow of foreign investments and a sharp decline of foreign exchange reserves. But this was not the case with the US, which could simply settle international debts by issuing more dollars.

What best bespeaks the US dollar's special status is that as all countries calculate their foreign exchange reserves in dollars, the value of dollar assets remains unchanged, whether the US dollar devaluates or appreciates in relation to other currencies.

In particular, to the US, with its dollar assets unchanged, the devaluation of US dollars to another currency would mean a rise in value of the very foreign exchange reserve the US holds.

That's why the US has been so actively promoting devaluation of US dollars to other currencies, especially the yuan nowadays, said Fan.

And the result of excessively promoting the dollars' status was the over issuing and over devaluation of the currency.

As the US hardly noticed the potential risks hidden in the practice, it tended to loosen its supervision, and this finally resulted in the crisis, Fan observed.

The current dollar standard currency system was established in 1971, when US President Richard Nixon unilaterally canceled the Bretton Woods system and stopped the direct convertibility of the United States dollar to gold.

Before that, under the Bretton Woods system, central banks of countries other than the United States were given the task of maintaining fixed exchange rates between their currencies and the dollar, while dollar was convertible into gold at US$35 per ounce.

However, in 1971, inflation in the United States and a growing American trade deficit were undermining the value of the dollar to such a great extent that the US finally abandoned the fixed value of the dollar and allowed it to "float."

Unlike gold, which is a super-sovereign reserve currency that may serve unselfishly for countries all over the world, the US dollar is first of all the currency of the US, which inevitably uses it to serve its own interests, Fan observed.

Creative reform

Acknowledging the dangers of relying on one nation's currency for international payments, Zhou Xiaochuan, the Chinese central bank governor, wrote an essay last month, calling for a super-sovereign reserve currency to replace the dominant US dollar.

"The crisis called again for creative reform of the existing international monetary system towards an international reserve currency," he said.

He was of the opinion that the reserve currency should not only be the unit in which a government holds its reserves, but should also be used for trade, investment, pricing commodities and corporate bookkeeping.

It is not surprising that the proposal was flatly rejected by US President Barack Obama, who insisted that investors considered the US "the strongest economy in the world with the most stable political system in the world" - even as it was reeling from a prolonged recession stemming from financial turmoil.

After all, a new reserve currency would deprive the US of all the special status it now enjoys with its currency being the reserve currency.

"The new currency could at least enable many countries (other than the US) to get rid of or diversify the risks of US dollars and dollar assets to some extent," Sun Lijian pointed out in an article published in Shanghai Daily on April 6. Sun is professor of finance and executive vice dean of the School of Economics at Fudan University.

As Sun reiterated, if the world economy continues to be monopolized by US dollars, similar systematic risks to those we are facing today will occur again sooner or later, due to the lack of an effective counter balance system.

(Shanghai Daily April 17, 2009)

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