Deep Dive

The Icarus Zone

Never before has a monetary union been so full of anticipation and hype. Should we have known that the euro would buckle?

It was not supposed to turn out like this. At the core of the euro, the supranational currency at the heart of the Economic and Monetary Union (EMU), is a tale of faltering ambitions and unrequited hopes. Launched in 1999 as one of Europe's brightest success stories, the single currency has become a saga of Wagnerian intensity, full of interweaving subplots in which the grandest designs have been subverted, the most beguiling intentions contorted, the most elaborate political calculations turned to dust. Monetary union threw a veil of comfort and well-being over the fortunes of the continent. In 2009 and 2010, the veil was ripped away.

With a unified monetary and interest rate policy that by 2011 encompassed 17 countries, the EMU and its key institution, the Frankfurt-based European Central Bank (ECB), were conceived as breaking down barriers between people, companies, and markets -- a force for unity and prosperity following the fall of the Berlin Wall, the reunification of Germany, and the ending of the communist-capitalist divide.

Some of the euro's achievements are incontestable. The euro area makes up one-fifth of the global economy and contains a population of 330 million -- in economic size, roughly equivalent to the United States. The ECB, keen to uphold a rigorous monetary reputation, has built up respect and acumen in the councils of monetary power around the world. The euro is the second-most important international currency after the dollar, of major significance in financial market transactions and in the holdings of central banks, pension funds, insurance companies, and government agencies around the world. In cash terms, there are 15 to 20 percent more euros in worldwide circulation than dollars.

Yet, a dozen years after its birth, the EMU has become Europe's melancholy union. The roots of its travails, or at least some of them, lie outside Europe: the buildup of massive, footloose investment capital by fast-growing developing nations like China; tightened conditions for international borrowing and lending after the U.S. home loans crash in 2007 and the downfall of New York investment bank Lehman Brothers in 2008; and then, in 2009, the worst world recession since the 1930s. But the central reasons for the dashing of European dreams have been relentlessly homemade. They lie in the EMU's inherent encouragement, through the "one-size-fits-all" interest rate policy, of vulnerable member states to live beyond their means, and in the extraordinary failure of Europe's governments and financial authorities to heed the warning signs and take corrective action until it was far too late.

The euro's advantages were meant to be self-fulfilling; success would feed on itself. Yet as a result of the defects revealed in 2009-2010, European countries have had to embark, within a period of just two years, on a massive program of financial overhaul for which they were almost completely unprepared and which dwarfs, in real terms, the sums of money mobilized to repair Europe after the end of the first and second world wars. The single currency bloc stands revealed as a zone of semipermanent economic divergence, corrosive political polarization, and built-in financial imbalances, beset by a perpetual penumbra of hope and pain. For the broad mass of the European electorate, "Europe" has become a byword for unpopular and painful economic restructuring. In allocating funds to prevent payments and debt disparities from destroying the euro, EMU governments have decided to commit colossal sums of taxpayers' money they cannot afford to heal internal disparities they cannot conceal to shore up an edifice many believe cannot stand -- at least, not in its current form.

To correct the malignant effects of years of economic recklessness, Europe, backed up by the International Monetary Fund, is imposing austerity and belt-tightening on the problem-ridden peripheral states led by Greece, Ireland, and Portugal, in exchange for emergency financing to help them pay their massive debts. These countries, three of the smaller economies in the euro, ran into serious problems in 2009-2011 as a result of a large increase in debts built up due to low interest rates and faulty supervision after the monetary union started, with the Greek imbroglio considerably worsened by government manipulation of key statistics that camouflaged the true extent of the country's economic deterioration. As part of crisis measures, the creditor nations -- with Germany in the vanguard -- are being asked to join in the sacrifices by taking a soft line over repayment of the problem states' existing debts, as well as by guaranteeing new ones.

European banks, severely weakened in many cases by the collapse of the pre-2007 global credit boom, have been drawn into the fray through their involvement as owners of hundreds of billions of dollars of government bond issues of the hard-hit peripheral states. European governments, powerfully backed by the ECB, have been reluctant to see the banks suffer outright losses through restructuring of the deficit nations' debts. The result is that responsibility for bailing out the errant eurozone members has been inexorably shifting away from the banking sector to taxpayers in the better-off countries.

This is exemplified most dramatically by the significant risks for national exchequers built up through the lending policies of the ECB, the capital of which is backed above all by Germany and France. The chief characteristic of this new European interdependence -- neither expected nor, for the most part, properly explained by political or monetary leaders -- is not freely exchanged solidarity, but growing resentment and recrimination. In a spiral of mutual discontent in some ways reminiscent of the atmosphere engendered by demands for reparations from defeated Germany after the First World War, both creditors and debtors look likely to revolt: the former, against the prospect that they will not be repaid; the latter, against the onerous conditions attached to loans made in the spirit of an economic union that has become increasingly discredited.

Whatever the setbacks it has faced and the strains it will continue to suffer, the euro is most unlikely to collapse and disappear. Too great has been the expenditure of political and economic capital, too arduous the efforts of many governments from many nations over many years, for the product of their labors simply to wither and die. Nonetheless, the system clearly faces the danger of fragmentation, with either strong or weak countries separating from the system and reintroducing -- despite all the costs and upheaval -- some form of national currency management more suited to their economic requirements.

One development holding the bloc together is that preserving the euro has become a strategic priority for China, the world's second-largest economy, No. 1 reserve currency owner, and main creditor nation, holding one-third of all foreign exchange reserves. The People's Bank of China, the Chinese central bank, and the State Administration of Foreign Exchange (SAFE), the country's premier sovereign wealth fund, have emerged as strong buyers of the euro in a bid to diversify their reserves away from the dollar. (To a more moderate extent, Japan has been following the same policy.) China does not want to be exposed to a chronically weak European currency when its own exports are being hit by rising inflation at home and by the threat of protectionism in some of its main markets, led by the United States. And neither China nor Japan wishes the Americans to benefit indefinitely from the unchallenged monopoly power of the dollar.

Additionally, both China and Japan have strong political reasons for winning favors from the Europeans at a time of economic upheavals. China would like to use the leverage of aid for the euro as a way of gaining relaxation of controls on technology flows from Europe in sensitive militarily relevant areas, and also to advance ways of purchasing industrial and service companies and logistics and transport facilities throughout the continent. The single currency has thus been caught up in China and the United States' battle over the future of the world economy.

In their involvement in these skirmishes, however, European policymakers have been reduced to the role of bystanders. Europe's objective in creating the euro had been to become an essential part of a new trilateral currency system in which America, Europe, and China parleyed over power; the monetary future of the globe would be in the hands of a triumvirate of central banks, the Federal Reserve in Washington, the ECB in Frankfurt, and the People's Bank in Beijing. In fact, for all the ECB's undoubted accomplishments, grave flaws in the political governance of the euro have placed the Europeans in positions of weakness rather than strength. In the eyes of its supporters as well as its detractors, the euro has been signally downgraded. The single currency that is emerging from the economic wreckage left by the European sovereign debt upheavals will be significantly different from that planned by its protagonists. The eurozone will be divided rather than united by diversity, fragmented into opposing blocs of creditor and debtor states, and condemned to years of costly and complex financial underpinning through the monetary equivalent of medical life-support machinery. A two-speed Europe has become reality, made up of a northern group of relatively integrated, homogeneous, and cohesive creditor states around Germany and the Netherlands, and a more diverse collection of hard-hit debtors on the periphery -- Italy, Spain, Portugal, Greece, and Ireland. France, which is politically and economically close to Germany yet prone to long-lasting tensions with the Germans over running the monetary union, is sandwiched uneasily between the two groups.

As a result of persistent Franco-German differences and a general ebbing of European desires for more integrated political structures, any new framework for the single currency will fall a long way short of the full-blown political union envisioned by the EMU's founders. Helmut Kohl, the German chancellor who pushed through reunification, worked tirelessly to replace the previous German national currency, the D-Mark, with the euro as a sign of reunited Germany's strong pro-European credentials, but his parallel objective of political union has long ceased to be realistic. As many skeptics had earlier predicted, events in Europe since 2009 have produced a textbook display of the drawbacks of establishing a "one-size-fits-all" monetary policy without thoroughgoing political interlinkages -- above all especially fiscal solidarity offering automatic redistribution of tax income among stronger and weaker countries. The fiscal rules of the so-called Stability and Growth Pact, established in 1997 as a means of maintaining EMU members' macroeconomic and budgetary probity, have proven woefully inadequate. The "no-bail-out clause" at the heart of the EMU's statutes agreed in Maastricht, laying down that member states had no liability for each other's debts, has been insufficient to prevent financial contagion, via which individual states' payments difficulties upset other members' fiscal health.

At the heart of the eurozone's gradual transition to a state of misery was a gross misreading of the laws of economics. The architects of the monetary union believed that individual euro countries' disparities in balance of payments performances -- caused by diverse rates of economic growth and inflation -- would have a negligible impact on the resilience of the eurozone as a whole. According to this notion, individual countries' current account deficits -- especially vis-à-vis other member countries -- would be largely self-financing. This ultimately proved to be pure fiction. But, since it appeared to be true in the early years of the EMU, the thesis attracted a great deal of support from within and beyond Europe -- and ended up promoting a self-perpetuating process in which spendthrift governments, companies, and consumers were rewarded rather than penalized by the financial markets. During negotiations on the Maastricht Treaty, the old European Community provision for mutual balance of payments assistance was removed. This reflected both the German-led view that monetary union should embody optimal discipline for member states and the belief that, once the new currency was created, financing current account deficits within the eurozone would no longer present difficulties.

But because within a single currency area devaluations are no longer possible, states on Europe's southern and western fringes such as Greece, Ireland, Portugal, and Spain with higher inflation effectively had exchange rates that were far too high, pricing their goods and services out of business in international trade. The Europe-wide fall in interest rates to German levels was used in the more inflation-prone peripheral countries not to build up productive capacity and prepare economies for the challenges of technological change and foreign competition, but to fuel wasteful consumption and speculative purchases of financial assets and real estate whose values subsequently plummeted. Since interest rates in the first eight years of the euro were plainly too low in peripheral states, these countries experienced credit booms, leading to above-average growth rates and also higher inflation and thus a loss of competitiveness -- setting off increasing balance of payments deficits that had to be financed by foreign borrowing. Countries such as Germany had the opposite experience: lower growth rates and inflation, resulting in higher competitiveness and large current account surpluses that were subsequently channeled back as loans to the deficit states, effectively pouring oil on a slow-burning monetary fire.

In August 2007 -- the month when the transatlantic credit crisis erupted internationally with the bursting of the bubble in the U.S. subprime mortgage sector -- the ECB published a 12-page article devoted to global imbalances in current account surpluses and deficits, saying, "The issue is important, as a potentially disorderly unwinding could pose a risk for the global economy and the stability of the international financial system." The article focused on the rise in the U.S. current account deficit "to unprecedented levels" and on the surplus countries of China, Japan, Russia, and Saudi Arabia. But it failed to mention the imbalances within the eurozone on the grounds that the current account position of the EMU countries had been "broadly balanced" and had even contributed to international adjustment by moving to a small deficit in 2006.

This was a telling sign of how the ECB in its myriad statements and publications habitually gave prominence to financial and economic statistics on the eurozone as a whole, virtually ignoring national data from individual members.

In an unwitting prophecy of the Greek unrest just two years later, the ECB wrote in August 2007, "[I]t is hard to define which countries are systemically important: some past financial crises have been triggered by relatively small economies." However, the bank failed completely to spot how the seeds of turbulence were being sown by developments within the eurozone itself. Unregistered by the ECB's statistical coverage, euro members in 2006 recorded some of the world's largest balance of payments disequilibria. Greece, Portugal, and Spain respectively ran up deficits of 11, 10, and 9 percent of GDP, while Germany and the Netherlands earned surpluses of 6.5 and 9 percent. In all cases, these imbalances were even larger than that displayed by the United States, with its current account deficit of 6 percent of GDP that year.

The self-delusion about the inviolability of the euro during the EMU's first decade coincided with widespread propagation around the world of three further tenets of central banking lore that also turned out to be false: that producing a low and stable rate of inflation was both necessary and sufficient to develop growth, prosperity and employment; that a combination of price stability and adequate supervision of individual financial institutions would buttress the stability of the financial system as a whole; and that movements of prices on financial markets would turn out to be self-correcting, without the necessity of large-scale intervention by government authorities.

As these delusions persisted, inflows of international capital allowed governments across the eurozone to borrow more or less at the same low interest rates as Germany. The ECB was only too happy to accept the apparently benevolent interpretation of international bond investors. As part of its refinancing operations, the bank accepted government paper from banks at virtually the same price throughout Europe, in line with the fiction that the euro area really had become one single political and economic bloc in which individual governments could borrow on near-identical terms, regardless of their economic circumstances.

As well as buttressing the notion that the monetary union had come of age, the equivalence of borrowing eased the ECB's task of establishing harmonizing economic conditions throughout the eurozone. Financial markets compounded the sense of well-being by setting aside traditional analytical tools (or even common sense) governing the pricing of financial risk, and valuing government debt as though Greece and other less well-off states really did have the same creditworthiness as Germany. This resulted in a self-fueling process in which the sharp reduction in interest rate spreads between different classes of borrowers persuaded the politicians that the monetary union was succeeding far more resoundingly than many had expected. Governments thus had no further incentive to carry out unpopular structural reforms at home to underpin the long-term health of the monetary union; the financial markets seemed to have done their work for them.

Once that complacency was punctured in late 2008, the apparently benevolent European cycle suddenly became vicious, turning out to be as short-lived and as illusory as the asset bubbles on which it was built. As Herman Van Rompuy, the former Belgian prime minister who in 2010 became president of the EU's governmental body, the European Council, put it in June 2010 with rueful pathos, "The euro became a strong currency with very small interest rate spreads [on government bonds]. It was like some kind of sleeping pill, some kind of drug. We weren't aware of the underlying problems." Referring to Europe's complacency about allowing countries like Greece and Portugal to run persistent annual current account deficits of 10 percent of GDP without insisting on corrective action, former West German Chancellor Helmut Schmidt said in late 2010, "The question is: How come that no one took any notice -- in Basel or in Brussels or in some statistical office? No one seems to have understood."

Warnings that monetary union would lead to unsustainable surges in borrowing had in fact been made by authoritative figures such as Hans Tietmeyer, president of the Bundesbank during preparations for EMU in 1993-1999. Tietmeyer spoke frequently in the pre-euro years of the risk that EMU states that generated higher inflation than Germany would suffer losses in competitiveness that could no longer (as in the past) be offset by devaluation but could be withstood only by lowering the internal prices of internationally traded goods and services and, in the last resort, through higher unemployment. Gerhard Schröder, Kohl's successor, who presided over the advent of the single currency in 1999, commented in 1998 that the EMU would increase Germany's industrial domination of Europe because its competitors would be unable to devalue their currencies. Such statements, accompanied by similar warnings from academic economists in many countries, represent strikingly accurate predictions of what actually happened.

As Europe awakens from its narcotic spell, the bitter truth is that very few of the strategic motivations for the formation of the single currency have been fulfilled. The progenitors of the Maastricht Treaty -- led by France and Italy, as well as smaller countries such as Belgium and the Netherlands, but including, too, most of Germany's leading politicians -- foresaw a variety of benefits. The four main arguments for the euro were to promote European growth and prosperity by eliminating exchange risks and boosting trade; to complete France and Germany's postwar political rapprochement by establishing a path toward political union; to create a rival and complementary force to the dollar; and to constrain the perceived dominance of newly reunited Germany. Needless to say, none of these predictions have borne out; Germany, for instance, is more dominant in Europe than ever. Never before had the creation of a new monetary device been so replete with anticipation and hype; it was almost inevitable that, under the weight of these expectations, the euro would buckle.

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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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