Q: What inspired you to write this book?

A: The theme of the book is how the U.S. current account deficit is destabilizing the global economy. The deficit has become so large, about $850 billion last year, that the countries with surplus current accounts are developing economic bubbles. Those dollars are reinvested in the United States and thereby also blow the US economy into a bubble. In other words, the trade surplus results in a global credit bubble. The book deals with the mechanism behind the bubbles and examines how foreign exchange reserves grow.

I am an American, but I have spent most of my career in Asia, including Thailand, where my experience was crucial for understanding the bubbles. In 1998 I went to work for the World Bank in Washington and I spent a couple of years on issues related to the Asian crisis. The book came out in 2003, followed by an updated edition in 2005.

What I realized in Thailand is that anytime a country experiences a very rapid buildup in its foreign exchange reserves, it tends to develop an economic bubble. For example, after the Bretton Woods Agreement broke down in the early 70s, Japan developed a very large trade surplus with the U.S. Its foreign exchange grew rapidly and, by the end of the 1980’s, the bubble was so great that the Imperial Gardens in Tokyo were valued higher than California.

In the 90’s the Asian countries experienced a rapid buildup in their foreign exchange reserves and they all turned into bubbles. Today China is the best example because it is the extreme case. Now the country has almost $1.5 trillion in foreign exchange reserves. Just over the last year the increase has been half a trillion dollars. The dollars go into China because of its large trade surplus with the U.S. and because of the substantial direct investment in building factories there.

Because the Central Bank of China does not want the Chinese currency to appreciate, it intervenes to buy up all the dollars that come into the country. The result is rapid deposit growth, which leads to rapid loan growth, which eventually leads to economic overheating and bubbling. To get enough money to buy all the dollars coming into the country, the Central Bank of China does what all central banks do - they wave their magic wand, which means printing money. That’s how the foreign exchange reserve grows.

Once the dollars are in the reserve, they need to be reinvested into dollar-denominated assets to produce interest. So the dollars end up flooding back to the U.S. as China buys Treasury, agency, corporate bonds, and asset-backed securities. The reinvestment is so large that it blows the U.S. into a bubble as well and the result is a global credit bubble.

Q: Would you explain to our readers how the international monetary system works?

A: Under the Bretton Woods system, which maintained a gold standard, such large trade imbalances were impossible over a long period of time. At the time classic economic theory was developed, if England had a big trade deficit with France, England’s gold would be shipped to France to pay for the deficit. The size of the country’s credit was a function of how much gold its banks had. If the gold left England, then credit would contract and the economy would go into a recession. Unemployment would go up, wages would drop, and prices would fall due to deflationary pressures.

The opposite would happen in France, which would have more gold, expanding credit and economy, and inflation. It wouldn’t take long before the rich people in France start buying more products from England, where the prices are falling. And at the same time, the English demand for French products would decrease. So the trade balance would adjust through the automatic mechanism inherent in the gold standard.

This automatic adjustment mechanism broke down with the Bretton Woods system. We have seen the countries with surpluses, such as Japan, reach extremely high levels of asset price inflation. Deficit countries, such as the U.S., are not deflating, however, because, unlike under a gold standard, there is no limit on the amount of paper dollars or the Treasury bonds denominated in dollars that can be issued.

Since there is no formal arrangement to replace the Bretton Woods system, the current international monetary system can be probably best described as The Dollar Standard because the dollar is the main globally accepted currency. However, the dollar standard cannot prevent the trade imbalances, which have resulted in bubbles both in the surplus and deficit countries.

Q: Is there any inherent correction mechanism in the dollar standard? The Japanese economy, for example, eventually did correct itself.

A: Eventually, every bubble pops because prices become so high that the underlying income is insufficient to finance the mortgages raised, for instance. That has been the case in Japan and that’s the case in the U.S. Bubbles are inherently unstable once they become big enough. They continue only so long as credit is expanding.

In the Japanese case, the bubble popped around 1990, when the government had a relatively low level of debt at about 40% of the GDP. Today, after 15 years of recession, the debt level has increased to 185% of GDP. It is the aggressive increase in government spending that prevented Japan from having a complete economic depression.

Q: Would you agree that the current dollar standard is exporting inflation around the world, especially in Asia? What are the consequences of the fact that the U.S. can keep printing dollars?

A: It is a very interesting issue to discuss. Certainly, the U.S. plays a leading role in this process, but we must not overlook the role of China, India, and other countries, which print their own currencies, even at higher rates than the Fed. There are two sides of this coin - the U.S. trade deficit flooding the world with dollars and the global central banks printing their own money to buy those dollars to prevent their currencies from appreciating.

Those two events cause inflationary pressures, which aren’t too acute now, but can get worse. If they do get worse, the Fed will have a very difficult choice. It will be forced to increase interest rates to stamp out the high levels of inflation, but the increasing rates would cause the property market to crash even worse and would throw the U.S. into a recession. That would definitely cause a global recession.

Then we would very quickly move from inflationary pressures to a deflationary environment and we would suddenly realize that there’s a tremendous excess capacity across most industries. And deflation is worse than inflation because it is not at all certain that the central banks know how to stop deflation. After all these years, Japan is still in deflation.

The other choice open to the Fed would be to ignore the higher rate of inflation. In that case, inflation in the United States could retune to the levels hit in the 1970s when CPI inflation reached 15%.