2009-10-07

The cost of reserve currency status

While the U.S. government enjoys seigniorage privileges thanks to the U.S. dollar's status of reserve currency, the American people do not derive much benefit. It is possible for Americans to benefit, but since the government's main objectives are welfare, warfare, and bailing out bankers, the people end up paying the bill for the extra power that accrues to USG through the printing press.

Andrew Sheng discusses some of the problems of reserve currency status in Prestige, Pitfalls and Perils of a Reserve Currency
There are also disadvantages. A country that allows its national currency to become a reserve currency is also letting foreigners hold large amounts, and letting the currency move freely in and out. Hence, one pre-condition for any reserve currency is the ability of an issuing central bank to control the currency's value through appropriate monetary policy. This implies a stable exchange rate as well as low level of inflation.

This is precisely the problem facing the U.S. dollar. It's called the Triffin Dilemma – a tension between national monetary policy and global monetary policy. In 1998, when the U.S. Federal Reserve realized the world was plunging into a global crisis, it lowered interest rates and reflated not only the U.S. economy, but also the global economy. The United States could do that because it was fundamentally strong and U.S. consumption was the real engine of global growth.

But constant deficits add up to excessive borrowing, which is unsustainable. The dilemma is that, in a world of freely flowing capital, any central bank that raises interest rates to control domestic borrowing will invite a ton of hot capital, creating asset bubbles. A country that maintains flexible exchange rates will not only have exchange rate appreciation that encourages imports, but also worsen a current account deficit funded by short-term capital inflows.

In other words, the Triffin Dilemma imposes high costs on a reserve currency country, which must run a deficit to increase global money supply when the world demands greater liquidity. But if a reserve country runs a deficit that's too large, a financial crisis is inevitable. There is no free lunch.

Can we resolve the problem by creating a global central bank and a global super-regulator? The answer is no. If we have global monetary policy, some regions and sectors will be winners and some will be losers. Thus, a pre-condition for a global central bank is a global fiscal mechanism that can tax winning sectors to compensate losing sectors. Without such a fiscal compensatory mechanism, no sovereign country will be willing to cede its monetary policy to a global central bank without assurance of at least some fiscal assistance. The euro can work with the European Central Bank because such a fiscal mechanism exists within the European Union.
Today, many people worry that the United States will lose its reserve currency status. This misses several crucial points:

1. No other nation wants reserve currency status. Reserve currency status benefits highly financial economies or nations that prefer political power to broad economic health. The U.S., as the world's wealthiest large nation, could afford to sacrifice some economic gains for political gains. What nation can afford political gains at the expense of their economy? What country wants their currency to appreciate against the U.S. dollar? What country wants to run large trade or capital deficits with the United States?

Think of it this way. The reason why the U.S. may lose its reserve currency status is because the value of the dollar is no longer stable. Whatever country or countries choose to become the new reserve currency, they cannot rapidly depreciate their currency against the dollar. Furthermore, if the U.S. dollar is strong, then it will once again become the reserve currency. The U.S. dollar loses reserve currency status is if it is weak and stays that way, or at least stays volatile.

2. The U.S. government wants reserve currency status. Reserve currency allows a nation to run a large deficit and aids in warfare especially. Crates of U.S. dollars are sent to Afghanistan, not crates of euros or yen. As much as the government's policy hurts average Americans, the politicians love the power it accords them.

3. The reserve currency must be fungible. At the end of the day, American dollars have value because Americans sell things people want to buy. Lately, that's mostly Treasury bonds, stocks, and real estate.

Reserve status was hurt when the Americans told the Chinese there are some companies they are not allowed to buy. Are the Europeans, Japanese, Russians or Chinese more or less open with their economy?

4. The end of reserve currency status will be decided by Americans, not foreigners. All the current plans put forth will fail, though some sort of commodity based currency may be possible. But then again, weakening currency would then mean weakening against commodities, not the U.S. dollar.

A nation either has to step up to replace the U.S., or the U.S. must choose to step down.

Therefore, I expect that until China or India get to the point where they can replace the U.S. as the number one market for goods, services, real estate, debt, stocks, etc. (or at least most of those), we are unlikely to see foreigners want the U.S. dollar to lose reserve status.

The most logical outcome is that since the U.S. dollar needs to weaken, the rest of the world will weaken more. The chart to watch is not the U.S. dollar relative to other currencies, but U.S. dollar and other currencies relative to gold.

Please see Mish Shedlock's latest post, Gold And The Watched Pot Theory, for more reasons why the dollar is unlikely to drop against foreign currencies in the near future.

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