Deep Dive

An Exorbitant Burden

Why keeping the dollar as the world's reserve currency is a massive drag on the struggling U.S. economy.

France, Germany, China, and Russia are actively promoting the replacement of the U.S. dollar with an International Monetary Fund basket of currencies -- known as the Special Drawing Rights (SDRs) -- as the global reserve currency. The United States is resisting. Both sides have their arguments backward.

The SDR should indeed replace the dollar as the dominant reserve currency if we want to eliminate the tremendous global trade and capital imbalances that have characterized the world for much of the past 100 years. This will not happen, however, until the United States forces the issue -- which it seems unwilling to do, perhaps for fear that it would signal a relative decline in the power of the U.S. economy.

But the United States should, in fact, support doing away with the dollar. For all the excited talk of politicians, journalists, and generals, a world without the dollar would mean faster growth and less debt for the United States, though at the expense of slower growth for parts of the rest of the world, especially Asia.

A French economist once told me that too often when policymakers think they are talking about economics they are actually talking about politics. A case in point, perhaps, is the claim first made in 1965 by Valéry Giscard d'Estaing, then France's finance minister, that the dollar's dominance as the global reserve currency gave the United States an "exorbitant privilege."

Giscard may have thought he was discussing economic privilege, but while during the Cold War there may well have been political advantages to the use of the dollar as the dominant reserve currency, economically it held little benefits to the United States. If anything, it forced upon the United States an exorbitant cost.

According to most political commentators, there are two main privileges accruing to the United States as a function of the dollar's reserve status. First, it allows the United States to consume and borrow beyond its means as foreigners acquire U.S. dollars. Second, because foreign governments must buy U.S. government bonds to hold as reserves, this additional source of demand for Treasury bonds lowers U.S. interest rates.

Both claims are muddled. Take the first. It may be correct to say that the role of the dollar allows Americans to consume beyond their means, but it is just as correct, and probably more so, to say that foreign accumulations of dollars force Americans to consume beyond their means.

Can foreign governments really do this? It is easy to dismiss the argument with a snappish "No one puts a gun to the American consumer's head and forces him to consume!" This is, indeed, the standard rejoinder. But this absurd argument only indicates how confused most people, even economists, are about balance-of -payments constraints.

The external account is not simply a residual of domestic activity, even for a large economy like that of the United States. It is determined partly by domestic policies and conditions, but also by foreign policies and conditions, which in the latter case directly affects the relationship between domestic American consumption and savings.

How so? When foreigner central banks intervene in their currencies -- and otherwise repress their domestic financial systems -- they automatically increase their savings rate by forcing down household consumption. As their savings rise, the excess must be exported, often in the form of central bank purchases of U.S. government bonds.

If there is no change in the total amount of global investment, and since savings must always equal investment, by exporting their savings to the rest of the world, the savings rate of the rest of the world (i.e. their trading partners) must decline, whether or not they like it. The only way their trading partners can prevent this is by themselves intervening.

This is why when commentators insist that only an internally generated increase in the U.S. savings rate can reduce the trade deficit (and thus it is useless to look abroad for solutions), it is because they do not understand the global balance-of-payments mechanism. But U.S. savings -- like that of any open economy -- must automatically respond to changes in the global balance of savings and investment.

This may seem counterintuitive, but it automatically follows from the way the global balance of payments works. If foreign governments intervene in their currencies and accumulate U.S. dollars, they push down the value of their currency and will run current-account surpluses exactly equal to their net purchases. Purchasing excess amounts of dollars is a policy, in other words, aimed at generating trade surpluses and higher domestic employment.

The reverse is true as well: Because its trade partners are accumulating dollars, the United States must run the corresponding current-account deficit, which means that total demand must exceed total production. In this case, it is a tautology that Americans are consuming beyond their means.

But being able to take on debt is not a privilege. When foreigners actively buy dollar assets they force down the value of their currency against the dollar. U.S. manufacturers are thus penalized by the overvalued dollar and so must reduce production and fire American workers. The only way to prevent unemployment from rising then is for the United States to increase domestic demand -- and with it domestic employment -- by running up public or private debt. But, of course, an increase in debt is the same as a reduction in savings. If a rise in foreign savings is passed on to the United States by foreign accumulation of dollar assets, in other words, U.S. savings must decline. There is no other possibility.

So where is the privilege in all this? Ask any economist to describe the greatest weaknesses in the U.S. economy, and almost certainly the list will include the gaping trade deficit, the low level of savings, and high levels of private and public debt. But it is foreign accumulation of U.S. dollar assets that, at best, permits these three conditions (which, by the way, really are manifestations of the same condition) and, at worst, causes them to deteriorate.

Oddly enough, it seems the whole world realizes this state of play -- except the United States. Recently, certain Latin American and Asian central banks began diversifying out of the U.S. dollar and increasing their purchases of Japanese government bonds. But did Japan think itself lucky that it was finally going to be able to share in the exorbitant privilege dominated by the United States? That foreign purchases of bonds would force up the yen, force down the Japanese trade surplus, and allow Japanese consumption to rise relative to production?

Japanese authorities failed to see this as a positive. They began intervening heavily, buying U.S. dollar assets as a way of pushing down the value of the yen -- which effectively converted foreign purchases of yen into foreign purchases of dollars. They refused to accept any part of the privilege and insisted on handing it back to the United States. Consuming beyond your means, in other words, is considered a curse for other countries even as they insist that it is a privilege for the United States.

They are half-right. It is an economic curse because it forces the reserve-currency country to choose between rising unemployment and rising debt.

Must foreigners fund the U.S. government?

What about the second exorbitant privilege -- doesn't the huge amount of foreign purchases of U.S. government bonds at least cause interest rates to be lower than they otherwise would have been? After all, any increase in demand for bonds (assuming no change in supply) should cause bond prices to rise and, with it, interest rates to fall.

But of course this assumes there is no concomitant rise in supply; and here is where the argument falls apart. Remember that foreign purchases of the dollar force up the value of the dollar, and so undermine U.S. manufacturers. This should cause a rise in unemployment -- and the only way for the United States to attempt to reduce this level of joblessness is to increase its private consumer financing or public borrowing. (Technically, it can also increase business borrowing for investment purposes, but this is unlikely when the manufacturing sector is being undermined by a strong dollar).

To maintain full employment, the supply of U.S. dollar bonds must rise with the increased foreign demand for U.S. dollar bonds. Purchases by foreigners of U.S. debt, in other words, are matched by additional debt issued by Americans. But in this case, interest rates will not decline. The domestic supply of bonds rises as fast as foreign demand for bonds.

What if you believe, as most economists do, that trade is a more efficient way to create jobs than government spending or consumer financing? Well, then, the amount of additional American debt issued will actually exceed net foreign purchases, in which case increased foreign purchases of U.S. dollar debt may actually cause U.S. interest rates to rise.

Confused? There's an easier way of thinking about it. By definition, any increase in net foreign purchases of U.S. dollar assets must be accompanied by an equivalent increase in the U.S. current account deficit. This is a well-known accounting identity found in every macroeconomics textbook. So if foreign central banks increase their currency intervention by buying more dollars, their trade surpluses necessarily rise along with the U.S. trade deficit. But if foreign purchases of dollar assets really result in lower U.S. interest rates, then it should hold that the higher a country's current account deficit, the lower its interest rate should be.

Why? Because of the balancing effect: The net amount of foreign purchases of U.S. government bonds and other U.S. dollar assets is exactly equal to the current account deficit. More net foreign purchases is exactly the same as a wider trade deficit (or, more technically, a wider current account deficit).

So do bigger trade deficits really mean lower interest rates? Clearly not. The opposite is in fact far more likely to be true. Countries with balanced trade or trade surpluses tend to enjoy lower interest rates on average than countries with large current account deficits -- which are handicapped by slower growth and higher debt.

The United States, it turns out, does not need foreign purchases of government bonds to keep interest rates low any more than it needs a large trade deficit to keep interest rates low. Unless the United States were starved for capital, savings and investment would balance just as easily without a trade deficit as with one.

Rebalancing the scales

The fact that the world has a widely available and very liquid reserve and trade currency is a common good, but like all common goods, it can be gamed. When countries use the dollar's reserve status to gain trade advantage, the United States suffers economically -- without the benefit of exorbitant privilege. What's worse, the greater the subsequent trade imbalances, the more fragile the global financial system will be and the likelier a financial collapse.

If the world is to address these global imbalances, it cannot do so without addressing the part that currency intervention and accumulation play. Some 70 years ago, John Maynard Keynes tried to get the world to understand this when he argued in favor of Bancor, a supranational currency to be used in international trade as a unit of account within a multilateral barter clearing system. He failed, of course, and we have been living ever since with the consequences.

Perhaps things are improving. On the surface, it looks like the world is starting to understand the reserve currency mess, but still too much muddled thinking dominates. For example, government officials in many countries talk about promoting SDRs as an alternative to the dollar, but much of the reasoning behind it is bureaucratic thinking. The world doesn't hold more SDRs, their argument goes, largely because there isn't a better formal mechanism to create more SDRs. Fix the latter and the former will be resolved.

But this is not why the world's central banks don't hold SDRs. If any large central bank, like that of China, Japan, Russia, or Brazil, wanted to buy SDRs, it's not hard for it to do so. All a central banker would need to do is check Wikipedia for the formula that sets the currency components of the SDR and then mimic the formula in its own reserve accumulation. The recipe is no secret.

But most of the world's largest holders of U.S. dollars as reserves will never do this, because of trade constraints. By buying SDRs the central banks are implicitly spreading their reserve accumulation away from dollars and into those other currencies. In doing so, any country that tries to generate large trade surpluses by accumulating reserves would be forcing the corresponding deficit not just onto the U.S. economy, but onto other countries (according to the currency's component in the SDR). But Europe, Japan, and others have made it very clear, that they oppose these kinds of trade practices and will not allow their currencies to rise because of foreign accumulation.

The world accumulates dollars, in other words, for one very simple reason. Only the U.S. economy and financial system are large enough, open enough, and flexible enough to accommodate large trade deficits. But that badge of honor comes at a real cost to the long-term growth of the domestic economy and its ability to manage debt levels.

Without a significant reform in the way countries are permitted to hold U.S. dollar assets, there cannot be a meaningful reform of the global economy. If the SDR is truly to replace the dollar as the dominant reserve currency, it will not happen simply because there is a more robust institutional framework around the existence of the SDR. It will only happen because the world, or more likely the United States, creates rules that prevent countries from accumulating U.S. dollars.

Will this happen anytime soon? Probably not. Washington is mysteriously opposed to any reduction in the role of the dollar as the world's reserve currency, and countries like China, Japan, South Korea, Russia, and perhaps even Brazil will never voluntarily give up the trade advantages of hoarding dollars. But at the very least, economists might want to clear a few things up -- and let's start by abolishing the phrase "exorbitant privilege."  

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