A new financial order needed?

Reuters:

Threatened by a "financial tsunami," the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.

The commentary in the overseas edition of the People's Daily said the collapse of Lehman Brothers Holdings Inc (LEH.P: Quote, Profile, Research, Stock Buzz) "may augur an even larger impending global 'financial tsunami'."

The People's Daily is the official newspaper of China's ruling Communist Party, and the overseas edition is a smaller circulation offshoot of the main paper.

Its pronouncements do not necessarily directly reflect leadership views, but this commentary by a professor at Shanghai's Tongji University suggested considerable official alarm at the strains buckling world financial markets.

China's central bank earlier this week cut its lending rate for the first time in six years, a move analysts said was aimed at bolstering the economy and the battered stock market.

"The eruption of the U.S. sub-prime crisis has exposed massive loopholes in the United States' financial oversight and supervision," writes the commentator, Shi Jianxun.

"The world urgently needs to create a diversified currency and financial system and fair and just financial order that is not dependent on the United States."

Kenneth Rogoff:

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

But can this extraordinary vote of confidence in the dollar last? Perhaps, but as investors step back and look at the deep wounds of America’s flagship financial sector, the public and private sector’s massive borrowing needs, and the looming uncertainty of the November presidential elections, it is hard to believe that the dollar will continue to stand its ground as the crisis continues to deepen and unfold.

If this crisis goes any further and deeper, the chances of a run on the dollar intensify. The US Dollar's recent rise in value has been swift, especially when compared to its long term devaluation over the past year: The value of the Dollar dropped around 10% between August 2007 and the middle of March 2008 (source), a process which was accompanied by a rise in the price of oil and increasing levels of inflation.

There are reasons why the US Dollar is likely to fall.

The first is that interest rates in the US are so low that any overseas investors buying government bonds are unlikely to see a decent return. Interest rates are higher in the Eurozone, Australia and other places in the world.

The second is that, with the sharemarkets tanking in the US, overseas investors are unlikely to want to keep up direct investments in US companies. Put simply, the US is a toxic place to invest and international investors are likely to sell their US shares and then retreat from the US entirely.

Thirdly, the US economy, by running a current account deficit for such a long time, is geared towards borrowing and consumption. A recession will cause domestic consumption to drop, resulting in an eventual rebalancing of the current account - a process which will make US dollars less valuable for investors to hold.

I can assure you beyond any doubt whatsoever that any panicked sell-off of the US Dollar would be the last thing the US needs. This credit crunch is packing some serious damage already. Add to that inflationary pressures of a tanking currency and there will be a stagflationary period the likes of which America has never seen before.

The only real way to prevent the dollar from falling - and the only way to save it once a fall begins - is for the Fed to increase interest rates. Raising rates during a recession may seem counter-intuitive, but I can guarantee you that the alternative, hyperstagflation, would be even worse.