Is the International Status of the Dollar a Big Deal?
David R. Henderson has a thoughtful post that (among other things) endorses Paul Krugman’s recent thoughts on the significance (or lack thereof) of the dollar’s role as the world’s reserve currency. As David puts it, the role of seigniorage is relatively unimportant in its impact on Americans. In the comments I pushed back on David’s position, and I think it’s at the point where I should bring the discussion here.
Let me quote Krugman (which David does too) to get to the heart of our disagreement:
What is true is that the large holdings of US currency outside the United States — largely in the form of $100 bills, held for obvious reasons — represent, in effect, a roughly $500 billion zero-interest loan to America. That’s nice, but even in normal times it’s only worth around $20 billion a year, or roughly 0.15 percent of GDP.
In other words, what Americans basically get because of the dollar’s special status, is the ability to send abroad $500 billion worth of green pieces of paper, in exchange for $500 billion worth (in market value) goods and assets. So long as foreigners continue to hold those green pieces of paper, Americans never have to “make good” on the initial influx of goods (and assets) that the foreigners sent us. Viewed as an upfront loan of those goods–with a zero percent interest rate, since we don’t pay any interest on paper currency–that’s effectively a perpetual benefit to Americans of $20 billion per year, forever (so long as the situation lasts). That’s a big number in the abstract, but it’s small potatoes in the context of the huge U.S. economy.
I have two main objections to this demonstration:
First, I don’t see why we are converting it to an annualized, perpetual figure. Suppose a massive earthquake strikes California, causing $500 billion in damage. Putting aside the deaths, would David (or Krugman) say this was relatively unimportant, a mere blip for the US economy? (No broken window jokes, let’s stick to the monetary issue here.) After all, we could convert that seemingly huge $500 billion damage figure into a much more reasonable $20 billion per year, by saying the insurance companies and California residents will pay for the quake out of future income forever, rather than dealing with it upfront. Would that seem like an appropriate way to transform the number?
Second, I don’t think it’s right to count only foreign holdings of actual paper currency. Surely there are many foreigners who maintain checking account balances denominated in U.S. dollars, who would not do so if the dollar lost its status as reserve currency. Think of it this way: If we all agree that a Brazilian holding ten $100 bills under his mattress is conferring a benefit on U.S. citizens, then how does that change if–for reasons of convenience, security, etc.–he deposits those ten pieces of paper into a CitiBank checking account and never spends it, because its function is a hedge against the collapse of his own currency?
If you follow my logic, then surely the relevant number is much higher than $500 billion. We might even go further and include holdings of dollar-denominated assets, such as Treasuries and corporate bonds, held by foreigners. Presumably the demand for such assets would also plummet in the type of scenario in which the dollar loses its status as reserve currency.
In conclusion, I am still not convinced, but I’m willing to continue this discussion in case I’m missing something. But right now I still think a sudden loss in foreign confidence in the dollar would cause a substantial reduction in Americans’ standard of living.
Krugman doesn’t think that the US has an exorbitant privilege. I think Barry Eichengreen would disagree.
As you do in your post, Eichengreen draws attention to Treasuries. If the dollar weren’t the world’s reserve currency, foreign central banks would be less likely to peg to the dollar or defend/weaken their currencies by selling/buying dollars. It is therefore convenient for a central bank to amass a large quantity of liquid US treasuries. This creates an extra bit of demand for treasuries that probably allows the US to either pay lower interest or issue more debt without having to pay a higher interest rate penalty.
It would be interesting to see Eichengreen go toe to toe with Krugman on this one.
Graph of how much the US imports vs. exports since the Nixon Shock: http://4.bp.blogspot.com/-2AckXP7Dvcs/T3qxvo5d4xI/AAAAAAAACYc/fpxDjF1i5BM/s1600/Exorbitant_Privilege.jpg
Large perpetual trade deficits demand an explanation, and the international demand for dollars (and dollar-denominated assets) is the best one I’ve heard. Here’s a blog post that goes into great detail about how this situation came about, going back to the end of WWI: http://fofoa.blogspot.com/2012/04/peak-exorbitant-privilege.html The blogger also claims that the primary goal of QE is to absorb all the excess treasury debt that continues to be emitted, now that foreign demand has slackened.
Krugman’s offhand dismissals of these concerns illustrate his faith in the fundamental stability of the status quo. He dismisses the euro as a dollar replacement because of fractured bond markets, but if the dollar drowns in debt, would the world really want to use another debt-backed currency as its primary reserve asset? The Eurosystem has already shifted its forex reserves from dollars to gold. They know what’s coming, if not when.
Well actually I would tend to think it improves the extent to which Americans may be said to benefit from the Brazilian’s actions if he decides to lend it to a bank rather than keeping it under his mattress but maybe I’m not thinking about that hard enough.
It seems kind of naive to me to think that the effect would just be the immediately seen effects in dollar terms. Couldn’t it be that there are important things that themselves depend on 20 billion per year that would themselves be impacted if that suddenly disappeared?
Bobs point is that other money is at risk of flight as well. If the guy deposits his money, his money is not overseas and not counted in the total overseas figure.
Good point Murphy.
Umm…
Japan?
Japan engineered a weakened yen, and interest rates slightly rose, the sky hasn’t fallen yet…
“the sky hasn’t fallen yet…” well then everything must be fine I guess..
I don’t know about you guys but I’m getting a kick out of the idea that the Japanese economy is a model for what other countries should do.
You mean if I use coercion to reduce other people’s purchasing power only slightly, then because they don’t starve on the streets, my activity is justified?
Edward,
The controversy is over whether the US $ losing its world reserve currency status is a big deal or not, not whether weakening it is.
If your plan is to print vast amounts of US dollars and foist them on the world before they lose their value then it is a big deal because the rest of the world is already onto you.
If your plan is to work hard, earn your living and exchange value for value, then don’t worry, the US dollar is nothing more than a medium of exchange. Go on with your life. Best of luck with your business.
Tel I understand what you’re saying, but it’s more like this:
==> For decades the US government has engaged in policies that would have greatly reduced the standard of living of the American people, but were partially masked by the fact that the US dollar is the world reserve currency. If that should end, the full consequences of past US government policies will come home to roost.
So to say, “Hey, the dollar is just a medium of exchange, you’ll be fine if you keep your head down and mind your business” isn’t really comforting.
I don’t understand what Krugman means by “zero-interest loan to America.” Who’s America? I’m an American. I work and am paid in dollars. I use $100 of those dollars to buy a few cases of Carta Blanca from a sole proprietor in Mexico. He holds the dollars in his safe deposit box for the immediate future. Who’s loaned what?
Tel,
Great response. You make it clear.
I only wonder how much China is on to us and what are they doing in secret, to counteract our deceptive practices? Seriously, they have to be planning counter measures, defensive measures and maybe even offensive measures?
Well, they’ve been aggressive net buyers of gold for a while now.