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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Deep Dive

The New Triumvirate

Sayonara yen. By 2025, the renminbi, dollar, and euro will control the international currency system.

History has a strange way of repeating itself on the global stage, not only in terms of economic cycles, but also in the eruption of momentous global events. In the 1930s, the world's monetary system was dominated by three powers -- Britain, France, and the United States -- whose currencies, along with gold, served as the main international reserve assets. In the 1980s, the U.S. dollar, Deutsche mark, and Japanese yen ruled the international monetary system. Although the dollar has since become the unquestioned principal international currency, even through the global financial crisis, another iteration of the global currency triumvirate is on the horizon. Fast-forward to 2025, and a system centered on the dollar, the euro, and the renminbi is likely to have emerged.

Much can be said about why only a few national currencies have historically topped the international currency hierarchy and how a country's economic power and political clout can elevate a currency's status. And there's certainly debate swirling around the fate of the euro with the deep debt crisis currently engulfing eurozone sovereign borrowers. But clearly the big story behind the emerging multicurrency monetary system is the internationalization of the renminbi -- and how it will alter the international monetary landscape and the dynamics of the U.S.-China bilateral economic relationship.

But what's required for a new currency to take on an international role? For one, it must be capable of attracting foreign private and official players active in cross-border trade, investment, and financial transactions. An international currency must also serve the usual functions of money -- invoicing trade, anchoring exchange rates, denominating international claims, and holding official reserves -- in both its home country and on the global stage. While a currency may perform such functions in sequence en route to achieving global status, it is through the collective impact of all four functions that economies of scale are created -- sufficiently lowering transaction costs and propelling a currency into widespread use. This doesn't happen overnight: The international monetary system's use of particular currencies exhibits considerable inertia, explaining why a few currencies tend to dominate for a number of years or decades. Transformation within the international monetary system simply takes time.

At the current juncture, the U.S. dollar remains the most important international currency, crowned as such in the postwar environment of the mid-20th century, when the global economic order became reliant on a complementary set of tacit economic and security arrangements between the United States and its core partners. In exchange for the United States assuming the responsibilities of system maintenance, serving as the open market of last resort, and issuing the most widely used international reserve currency, its key partners -- Western European countries and Japan -- acquiesced to the special privileges enjoyed by the United States: seigniorage gains, domestic macroeconomic policy autonomy, and balance of payments flexibility.

The benefits of these privileges are potent. Estimates of seigniorage -- the revenues arising from the difference in the cost of printing dollars and the face value of dollars -- for the United States arising from foreign residents' holdings of dollar notes, for example, have averaged $15 billion per year since the early 1990s, and the United States is estimated to have benefited from a discount of $80 billion on its borrowing costs in 2010 alone, as a result of the dollar's international status.

Broadly, the global economic order revolving around the dollar remains intact, though hints of its erosion have emerged over the past decade. For the United States, the dollar's international reserve status and its safe haven characteristics, coupled with the country's large and deep capital markets and developed legal institutions, have allowed it to successfully sell huge amounts of government and corporate bonds to foreign investors. This success, however, does not remove credit risk or the risk that an abrupt loss of investor confidence could trigger a disorderly adjustment in U.S. asset prices and the value of the dollar. The downgrading of the U.S. credit rating by Standard & Poor's is a warning sign.

As of the end of 2010, foreign investors' exposure to the U.S. economy amounted to $22.8 trillion, close to half of the aggregate GDP of the rest of the world. Changes in U.S. monetary policy thus have a direct wealth impact on foreign residents, independent of how U.S. monetary policy affects global financial market conditions. A whopping 95 percent of foreign exposure to U.S. assets is denominated in dollars, which poses a difficult dilemma for foreign investors. Collectively, there's a strong incentive to maintain the value of their holdings by avoiding the risk of dollar depreciation that could undermine their investments -- despite the incentive individual investors have to diversify their portfolios as a matter of prudent risk management.

In the near term, the euro represents the strongest rival to the dollar, assuming the eurozone is able -- through bailouts and longer-term institutional reforms -- to successfully navigate a path out of the sovereign debt crisis currently plaguing it. But in the long term, the size and dynamism of China's economy and the rapid globalization of its corporations and banks put the renminbi in a position to take on a more important international role.

The troubled euro

The euro's current predicament is attributable, in a broad sense, to the global financial crisis and the 2008-2009 Great Recession. European economies have shouldered huge levels of public debt and growing government borrowing requirements during the episode, giving rise to mounting concerns about sovereign risk. Despite the general consensus that deterioration in public finances is of a cyclical nature, the scale of private risk transferred to the public sector, along with projections of growing long-term government outlays for health care and old-age entitlements, point to enduring structural budget gaps and growing levels of public debt to income. Thus according to OECD estimates, public debt in European countries has expanded considerably, with total OECD central government debt rising from 50.6 percent of GDP in 2007 to 71.7 percent in 2011; gross borrowing requirements are expected to reach a record $19 trillion in 2011, almost twice that of 2007. Successfully issuing such large volumes of debt would be challenging in the best of circumstances.

Given anemic growth prospects and uncertainty about the course of monetary policy in major global financial centers, capital markets have reacted by repricing European sovereign debt in a fragmented manner: Fear and anxiety now grip public debt issuance in eurozone periphery countries, while positive sentiment continues to drive trading in core eurozone sovereign debt. Peripheral countries like Greece and Ireland have been all but locked out of private markets, even though both groups of countries have issued debt in euros and are operating in a common monetary policy framework. The crisis has led the European Union to take several extraordinary steps toward remediation, such as the European Central Bank's Securities Markets Program, which purchases government debt of troubled countries through secondary markets, and the European Financial Stability Facility, which provides country-level guarantees to temporarily assist countries with budgetary needs and supports the financial stability of the eurozone as a whole.

Beyond the troubles in the eurozone, today's dollar-based international monetary system and the likely multicurrency system of the future share a number of systemic defects. The fundamental problem is an asymmetric distribution of the costs and benefits of balance-of-payments adjustment and financing. Countries whose currencies are key in the international monetary system benefit from domestic macroeconomic policy autonomy, seigniorage revenues, relatively low borrowing costs, a competitive edge in financial markets, and little pressure to adjust their external accounts. Meanwhile, countries without key currencies operate within constrained balance-of-payment positions and bear much of the external adjustment costs of changing global financial and economic conditions.

The dollar-based monetary system, though, is also associated with significant shortcomings that would be unlikely to be so prevalent in a multicurrency system, most notably the asymmetric distribution of the cost of adjustment to external conditions. It is precisely this scenario that has contributed to a dramatic widening of global current account imbalances in recent years. It has also produced a potentially destabilizing situation in which the world's leading economy, the United States, is the largest debtor; meanwhile, the world's largest creditor, China, assumes a massive currency mismatch risk in the process of financing U.S. debt. Another shortcoming of the dollar-based international monetary system is that global liquidity is created primarily as the result of the monetary policy decisions that best suit the United States, rather than with the intention of fully accommodating global demand for liquidity.

The rise of the renminbi?

In another instance of history repeating itself, the measures introduced by the People's Bank of China in July 2010 to stimulate the internationalization of its currency through the development of an offshore renminbi market in Hong Kong are considered landmark events in the financial community, in much the same way as the July 1963 issuance of a $15 million bond by the Italian highway concession company, Autostrade, was a groundbreaking transaction in the development of the offshore Eurodollar market. But the headline news misses the underlying economic forces and regulatory factors that shape the evolution of an offshore financial and trading market.

China already satisfies the underlying trade and macroeconomic criteria required for currency internationalization in some respects: a dominant role in global trade, a diversified merchandise trade pattern, and a macroeconomic framework geared to low and stable inflation. From a historical perspective, China's current position in global manufacturing exports is similar to that of the United States in the interwar period, when Britain's lead in manufacturing exports was steadily declining. On the other hand, China's lack of open, deep, and broad financial markets means that the renminbi falls far short of being a truly international currency at present. Limitations on currency convertibility in China also constrain the use of the renminbi as an international currency -- though the renminbi is convertible for current account transactions (that is, payments for goods and services), capital account inflows and outflows are subject to tight restrictions, making liquidity a problem.

Chinese authorities are adopting a novel approach in developing an offshore renminbi market while maintaining capital controls, one distinguished by pragmatism and a gradual pace. This strategy of "managed internationalization" involves actions on two fronts: the development of an offshore renminbi market, and encouraging the use of the renminbi in trade invoicing and settlement. Beijing's actions thus far suggest that authorities' initial focus is regional, starting with promoting the renminbi's role in cross-border trade between China and its neighbors. To that end, China began a pilot arrangement of cross-border settlement of current account transactions in renminbi in July 2009, focusing on transactions between five Chinese cities and Hong Kong, Macao, and the Association of Southeast Asian Nations (ASEAN) countries. This arrangement was extended in July 2010 to include all ASEAN countries and 20 provinces inside China. Currently, about 6 percent of China's international trade (roughly RMB 360 billion, or about $55.4 billion) is denominated in and settled in renminbi. This looks to be the start of a rapid upward trend. Renminbi-denominated trade settlement is expected to reach $1.3 trillion by 2015, providing a major source of offshore liquidity and capital market business.  

From a policy perspective, foreign currency exposure in China's external balance sheet provides a powerful incentive for Chinese authorities to promote renminbi internationalization. As of the end of 2010, China had borrowed less than one-quarter of its $630 billion of outstanding foreign debt in renminbi. The share of China's international lending denominated in renminbi has been negligible -- only 3.2 percent of the total -- partly due to the fact that foreign bonds could be issued only in foreign currency until mid-2007, when official and commercial borrowers were allowed to issue renminbi-denominated bonds in Hong Kong. Internationalization of the renminbi would help mitigate this tremendous currency mismatch in China's asset/liability position vis-à-vis the rest of the world.

Although international use of the renminbi has the potential to expand, the task ahead remains challenging. Expanding domestic debt markets, increasing the convertibility of the renminbi, reinforcing financial sector supervision, and establishing a more transparent framework for monetary policy are all necessary for the renminbi to become an attractive international (not just regional) currency. And these processes take considerable time to complete. Moreover, prospects for the renminbi also depend on the direction of East Asian monetary integration in addition to how quickly the inertia present in the current international monetary order can be overcome.

Implicit in any discussion of prospects for internationalization of the renminbi is consideration of the unmatched scope of bilateral economic interdependency between the United States and China. The United States accounts for a greater share of Chinese exports than any other country, while China is the largest foreign investor in U.S. government debt. At the same time, the massive global payment imbalances between the two economies have placed the U.S.-China bilateral relationship at the center of policy discussions regarding the need to reduce imbalances and rebalance global demand.

For the past four years, the U.S.-China relationship has been managed under the framework of the Strategic and Economic Dialogue, a series of high-level biannual meetings. This structure has provided an effective forum for engagement, negotiation, and strategic planning between the two countries on key bilateral issues ranging from currency regime to energy policy to the environment. But China's management of its exchange rate has been a reoccurring focus of this relationship, rendering it testy at times. This could change with the internationalization of the renminbi -- and it is in the interest of the United States, indeed the world, to encourage the process. With the renminbi increasingly serving as an international trading, funding, and eventual reserve currency, it would behoove China to be seen as acting on its own initiative rather than yielding under foreign pressure.

A more stable union

Defects of any international monetary system aside, policymakers would do well to recognize that moving toward a new iteration of the multicurrency monetary system offers the prospect of greater stability than under the present dollar-centered system. More even distribution of lender-of-last-resort responsibility and better provision of liquidity during times of distressed market conditions would be two major benefits of a multicurrency system. At the same time, diversifying the source of foreign exchange reserve supply may permit developing countries to meet their reserve accumulation objectives more easily and render stocks of reserves less exposed to the risk of depreciation. A multicurrency regime also has the potential to command greater legitimacy than a dollar-based system, particularly if countries issuing the main international currencies manage global liquidity consistently with global growth and investment, stabilize their bilateral exchange rates, and devise mechanisms for sharing the benefits of international currency status with other countries. And there is geopolitical advantage in expanding the benefits of an international currency to aid additional countries. While change may not yet be imminent, it is certainly in the air.

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