Paul Krugman concluded a recent post with, “The bottom line is that while saying “the international role of the dollar” sounds very sophisticated and important, the more you know about all this the less you care. This is simply not a big deal.”
Steve R Waldman has also previously posted somewhat skeptically about the significance of “US dollar hegemony”. This has come as a bit of a shock to me. I had fully taken on board the widely made case that the global economy is severely hampered due a national currency (the USD) also serving as the international reserve currency. I previously posted an attempt to explore ways in which this problem might be addressed. Should we instead be reassured that there isn’t any problem after all?
Just to be absolutely clear, there IS agreement that the USA could thrive without the USD being the global reserve currency -that isn’t the issue. I would totally understand if Paul Krugman were simply saying that it is no bad thing that China has arranged bilateral currency swap agreements with twenty other countries and that the USA should not intervene if oil producing nations agree payment in currencies other than the USD. My shock is that Paul Krugman dismisses the whole issue as inconsequential. I worry that complacency has come from the knowledge that our current system has been brought about by good-natured people -it is not the work of evil conspirators. I think it is vital to recognize that dreadful macroeconomic consequences can result without anyone having any malign intent. Once we take that on board, we will have a better chance of honestly appraising how things really are and that could help in avoiding tragic future mistakes.
Michael Hudson’s view is that, because the USD serves as the international currency for global trade, nations and companies need prices to have some semblance of price stability as denominated in USD or else they will not be able to compete in international markets. In Michael Hudson’s account, a sobering consequence of this is that other countries end up inadvertently funding the gigantic US military budget. The USA can have military bases across the world and the monetary authorities of other nations have to mop up that spending to avoid their own exporting industries becoming bankrupted. If monetary authorities across the world did not accumulate US treasury bonds as fast as the US military spent, then the USD would drop in value. If a factory is built or a mine is dug, then the flow of USD received from exports needs to be able to cover the cost of the initial investment and of wage contracts denominated in local currency. So long as the USD is used as the unit of account for global trade, this effect manifests even when the exports do not directly involve the USA and are between countries that have their own different currencies.
Rather than emphasizing the military, Greenwald and Stiglitz emphasize the accumulation of USD reserves for use as a buffer stock by monetary authorities seeking to moderate currency exchange rate fluctuations. By this account, much of the accumulated reserves of US treasuries are not wholly a “waste product” of efforts to counter the effects of runaway US current account deficits. Rather a significant stock is needed for use in crises when the local currency falls in value relative to the USD. Although the USA has run pronounced, sustained, current account deficits, the movements of currency exchange rates are far from smoothly in one direction. In times of financial panic, there is a flight to safety to the USD. In the 2008 crisis there was a dramatic fall in many emerging market currency values relative to the USD even though the crisis largely originated in the US housing market. In such circumstances, reserves can be drawn down to temporarily support the value of the local currency. As economies of developing nations grow, so the demand for these buffer stocks expands. Accordingly, even if the USA were to decide to radically scale back its overseas military spending, there would still be an awkward issue. Basically the USA, the worlds richest country receives real goods and services from far needier populations in return for electronic ledger entries -which is what the stock of US treasury bonds really amounts to.
A persuasive case can be made that the best policy can be to ride out exchange rate volatility without intervening. The calamitous 1997 Asian Financial Crisis actually prompted many countries to BOTH let exchange rates float considerably more freely than they had in the past BUT ALSO to amass much larger reserves of US treasuries for when intervention really was desperately needed. -A belt and braces approach for ensuring some semblance of national financial security. Such reserves need to be held as US treasuries rather than as some other currency because the significant exchange rate is that between the local currency and the unit of account for global trade. Imagine if a monetary authority had amassed reserves in the form of Australian Government Bonds rather than US treasuries. During the 2008 crisis, the AUD/USD shifted from 0.97 to 0.61 and so for the purposes of intervening to support the value of the local currency, AUD reserves would have fallen short just when they were needed. Furthermore, by their very nature, currency exchange rate interventions by monetary authorities are huge, market moving, trades. Selling off reserves of US treasuries during such a crisis intervention can act to depress the value of the USD, which helps towards the intervention. Contrast that with the consequence of the price impact of selling off reserves that were in some other currency.
To me a particularly incongruous passage in Paul Krugman’s post was: “There is no evidence that America is able to borrow dramatically more cheaply because of the dollar’s role (and anyway more foreign borrowing is not necessarily a good thing.) You often hear claims that we’ve only been able to run persistent trade deficits because of the special role of the dollar; this is just false, since other countries like Britain and Australia have been able to do the same thing. 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.”
First off, Paul Krugman’s emphasis of paper money rather than holdings of US treasuries seems utterly bizarre. That $500B held as paper money by foreigners is dwarfed by the $5.7T (ie more than eleven times as much) held by foreigners as US treasuries. I also struggle to see how this can be viewed as “a loan”. To my mind, a meaningful use of the word “loan” is for when a debt is to be repaid. What we are talking about here are stocks of US treasuries that are perpetually rolled over along with any interest that accrues. In reality, foreign holdings of US treasuries have conferred $5.7T worth of real goods and services to the USA as a pure seigniorage profit.
What of Paul Krugman’s counter examples of the UK and Australia? The UK has gone all out in tapping into another equally profound and damaging distortion in the global financial system by becoming a piggy bank for the world’s elite. I had a go examining that phenomenon in the post “Isn’t a financialized economy the goose that lays our golden eggs?”. In fact an analogy between the way that capital flows are enticed into UK asset markets and US dollar hegemony has led to Michael Goldfarb describing London real estate as a “global reserve currency”. The USA already partakes avidly in similarly enticing capital flows into US asset markets. That gravy train can only be spread so far and the US is a much larger economy to try and distort than the UK economy.
The Australian balance of trade has been in persistent deficit as Australian households have racked up more and more mortgage debt over a very long time period. Australia has a relatively small population and a lot of mineral wealth. That mineral wealth, together with the immigration restrictions that ensure exceptional high pay for mine workers, underpin the ability of Australian households to service those debts.
In trying to understand all of this, I found it helpful to try and imagine the consequences if some other country were to try to unproductively splurge with their own currency across the world on a scale comparable to the overseas US military bases. Let us imagine that after reading Paul Krugman’s blog, such a country decided to set up lavishly appointed cultural outreach bases in every city on earth. It would entail employing tens of thousands of interpreters, and bidding for building materials and local contractors to build the bases. Perhaps a million staff would live abroad to conduct the business of the bases, doing dance displays and such like, with it all being paid for out of the, now colossal, cultural outreach budget. My guess is that if an attempt was made to pay for all of that using Indonesian rupiah, Swedish krona, Japanese yen, Brazilian real or any other currency that was not the currency used for global trade, then the consequence would be a fully fledged slide in the currency value to the point where it became worthless and so the grandiose project had to be abandoned. The other countries couldn’t care less if all of their currencies appreciated dramatically relative to the Indonesian rupiah or Swedish krona. They would see no cause for intervening in the currency markets and no exorbitant privilege would be granted.
Edited on 28dec2013: expanded and amended the paragraph about Australia
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