The Washington Post reported on former Treasury Secretary, and soon to be former Harvard President, Larry Summers' suggestion that the foreign central banks of developing countries begin to unload some of their huge dollar holdings. As someone who has been writing on this issue for almost five years (see here, here, and here), I am glad to see that it is now getting attention from some prominent economists.
Unfortunately, the article (and perhaps Summers) confuses cause and effect. The article implies that the central banks acquire these huge holdings because of their countries' vast trade surpluses with the United States. It suggests that the banks buy up dollar reserves because they don't know what else to do with their money.
While there be some holdings due to simple confusion of this sort, this is probably the least important factor in the huge build-up of reserves. Part of the reason is that developing countries do not want to end up in financial crises where they can then be subject to the dictates of the I.M.F., as happened when Summers was running the show at the Treasury Department in the nineties.
However, the main reason is that foreign central banks are consciously trying to maintain the high value of the dollar relative to their currencies in order to sustain their large trade surpluses with the United States. How else could China sustain its under-valued exchange rate, if it did not buy up dollars? In other words, the cause and effect runs in the opposite direction from what is indicated in this article. Foreign central banks have decided to keep their currency under-valued against the dollar, which requires massive purchases of dollars.
This strategy can be an effective way to boost exports, but presumably there are better ways to stimulate demand over the long-term. In any case, it is important to recognize that it is the high value of the dollar that causes the trade deficit, a fact that is largely obscured by the discussion in this article.
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