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World Money Supply

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By LorenCobb
November 14, 2005

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The debate about Alan Greenspan's supervision of the US money supply often ignores a factor that is, in my opinion, the single most important driving force affecting the Fed's decisions. The Fed is charged with keeping the nation's money supply under rational control, but over the last 50 years or so the dollar has gradually become the primary source of liquidity for international trade. This has reached the point where the Fed can no longer make monetary decisions without taking into account their effect on international trade.

I remember well the monetary debates of the 1970s and 80s, when this process first attracted the attention of the press and financial institutions. A new word was invented: eurodollars, referring to dollars permanently circulating throughout Europe as the preferred medium for payment of trade debts. Economists and investors debated endlessly over the long-term significance of the existence of all those billions of dollars.

Fast forward to the 2000s, and money supply is once again a hot topic. This time, the entire world is using dollars for trade, though some of that function has been taken up by the new Euro. Literally trillions of electronic dollars slosh about from country to country, paying for international trade, and only infrequently passing through the accounts of an onshore bank.

Here's the point: every one of those trillions of dollars was created by the Fed, and represents a portion of our money supply. (Well, not every one of them: there are many billions of counterfeit and fraudulent dollars too.)

It's not just international trade, it is also the growing number of countries that have given up on their own currency and dollarized their economies: Panama, Ecuador, El Salvador, etc. Then there are the many countries, probably over 50 in number, which are partially dollarized. Partial dollarization means that the US currency is legal tender, and bank accounts can be denominated in either the local currency or the dollar. All of these countries are using US dollars to provide liquidity for their financial transactions. In other words, one needs to compare the US money supply not merely to the size of the US economy, but to the sum of the US economy and all dollarized foreign economies and all (prorated) partially dollarized economies.

As a thought experiment, consider what would happen if the Fed were to exercise an astonishing feat of financial magic that removed all international dollars from circulation. Trade would stop within 24 hours! The crisis would make the liquidity crisis of 1929-32 (caused by countless bank failures worldwide) look like walk in the park. I conclude from this that the apparent excess of dollars in our money supply has a function that helps the US in its role as the largest trading nation in the world, and (not coincidentally) financier to the world as well.

I don't disagree with charges that Greenspan has enabled two serious financial bubbles (the dot-com and housing booms), but I urge a degree of caution when thinking about the US money supply. These days it is absolutely impossible to separate our national money supply from the international. For at least the last two decades, the Fed has been managing the money supply of the entire world, not just the USA. That creates numerous problems that must be taken into account. To ignore the use of dollars by the rest of the world is to ignore the single greatest change that has occurred in the world's economy in the last 100 years.

Loren


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