Excerpted from Michael Pettis' China Financial Markets blog,
This may be excessively optimistic on my part, but there seems to be a slow change in the way the world thinks about reserve currencies. For a long time it was widely accepted that reserve currency status granted the provider of the currency substantial economic benefits. For much of my career I pretty much accepted the consensus, but as I started to think more seriously about the components of the balance of payments, I realized that when Keynes at Bretton Woods argued for a hybrid currency (which he called “bancor”) to serve as the global reserve currency, and not the US dollar, he wasn’t only expressing his dismay about the transfer of international status from Britain to the US. Keynes recognized that once the reserve currency was no longer constrained by gold convertibility, the world needed an alternative way to prevent destabilizing imbalances from developing.
This should have become obvious to me much earlier except that, like most people, I never really worked through the fairly basic arithmetic that shows why these imbalances must develop.
Kenneth Austin, a Treasury Department economist ecently published what I think is a very important paper in the latest issue of The Journal of Post Keynesian Economics (“Systemic equilibrium in a Bretton Woods II-type international monetary system”) which explains why currency war is really a battle over where to assign excess savings, and must lead to unemployment in the country whose assets are most assiduously collected by central banks. You need to subscribe to read the full article, but the abstract tells you what Austin set out to prove:
This article develops a model, based on balance-of-payment identities, of the new international monetary system (Bretton Woods II or BWII). It shows that if some countries engineer current account surpluses by exchange-rate manipulation and foreign-reserve accumulation, the burden of the corresponding current account deficits falls first on the reserve-issuing countries, unless those savings inflows are diverted elsewhere. The imbalances of the BWII period result from official, policy-driven reserve flows, rather than market-determined, private savings flows. The struggle to divert these unwanted financing flows is at the root of the “currency wars” within the system.
While recognition of the exorbitant burden had been growing in recent years, Austin’s article focused a lot of new attention on this topic, and it seems that finally Keynes’s insight is attracting the kind of acceptance that might eventually modify future policy. In August in a much-commented-upon article in the New York Times, Jared Bernstein explained one of the corollaries of Austin’s model, pointing out that
Americans alone do not determine their rates of savings and consumption. Think of an open, global economy as having one huge, aggregated amount of income that must all be consumed, saved or invested. That means individual countries must adjust to one another. If trade-surplus countries suppress their own consumption and use their excess savings to accumulate dollars, trade-deficit countries must absorb those excess savings to finance their excess consumption or investment.
Note that as long as the dollar is the reserve currency, America’s trade deficit can worsen even when we’re not directly in on the trade. Suppose South Korea runs a surplus with Brazil. By storing its surplus export revenues in Treasury bonds, South Korea nudges up the relative value of the dollar against our competitors’ currencies, and our trade deficit increases, even though the original transaction had nothing to do with the United States.
This is a key and much misunderstood point. The inexorable balance of payments accounting mechanisms make Bernstein’s claim – that “Americans alone do not determine their rates of savings“ – both necessarily true and joltingly shocking to most economists.
Because I have written about this topic so many times before, I won’t make the full argument, but it might be useful to remind readers why reserve currency status is an exorbitant burden:
1. Because for a variety of reasons dollars are the preferred form of foreign currency reserve, or of any “risk-off” kind of trade, in order to combat uncertainty or to increase domestic employment, foreign countries are most likely to accumulate reserves by buying US government bonds or other liquid, low-risk US dollar assets. This reserve accumulation might be formally classified as reserves, and accumulated by the central bank, or other institutions, some of which are referred to as sovereign wealth funds, might accumulate these reserves.
2. When it is the private sector that accumulates dollars, there are likely to be too many potential reasons and consequences to try to summarize them. But when governments systematically accumulate huge amounts of dollars, the reason has almost always to do with creating or expanding the trade or current account surplus, which is just the obverse of expanding the export of net domestic savings. The mechanism involves suppressing domestic consumption by taxing households (usually indirectly in the form of currency undervaluation, financial repression, anti-labor legislation, etc) and subsidizing exports. These mechanisms force up the savings rate while making exports more competitive on the international markets, the net effect of which is to reduce domestic unemployment.
3. If these savings are exported to the US, for example if the central bank buys US government bonds, the US must run the corresponding trade deficit. This has nothing to do with whether the exports go to the US or to some other country. It is astonishing how few economists understand this, but if Country A is a net exporter of savings to Country B, the former must run a surplus and the latter a deficit, even if the two do not trade together at all.
4. Does the US benefit from importing foreign savings and foreign investment? The local state or country that receives the investment may benefit, but any country only benefits from importing foreign capital under one or more of three conditions:
- When a country has high levels of potentially productive investment but domestic savings are insufficient to satisfy domestic demand, the country benefits from importing foreign capital to fund these productive investments. As long as the total economic return on these investments, including all externalities, exceeds the cost of the foreign borrowing, or is funded by foreign equity investment, foreign capital inflows are wealth creating for the recipient.
- When during a crisis major borrowers, including the government, face severe short-term liquidity constraints and domestic capital is, for whatever reason, unwilling or unable to fund maturing debt, foreign capital inflows can help bridge the gap. In this case foreign investors fulfill the classic role of a central bank, lending to creditworthy borrowers or against acceptable assets in order to prevent a liquidity crisis from forcing the borrower into insolvency.
- For countries that lack technology, that have weak business and management institutions, or that suffer from low levels of social capital, foreign investment can bring with it the technology and management skills that allow the economy
In the days of the gold standard it was possible for an advanced economy like the US to suffer from the first condition. Today it suffers from none of the three conditions.
5. Let me explain why it does not suffer from the first. If the US is a net recipient of capital inflows, it is simply taking the other side of the accounting identity I listed earlier: an excess of savings over investment in one part of an economic system requires an excess of investment over savings in another part. If Japan, with its undervalued currency and repressed interest rates, forced its savings rate up above its already high investment rate in the 1980s, and used the excess to by US government bonds, the US had to see its investment rate exceed its savings rate. There are only three ways in which the US can increase investment relative to savings, or reduce savings relative to investment:
- It can increase productive investment.
- It can increase nonproductive investment, especially in real estate, as foreign inflows unleash a stock and real estate market bubble, or it can increase consumption, as these bubbles unleash a wealth effect which causes ordinary Americans to increase their consumption relative to their income (i.e. reduce their savings). In either case US debt rises faster than US debt-servicing capacity.
- Unemployment can rise as the expansion in imports relative to exports causes American factories to cut back on production and fire workers. Of course fired workers no longer produce but they still must consume, so the savings rate drops.
These are the only three possible outcomes. If productive investment in the US has been constrained by the lack of American access to capital – domestic or foreign – as was the case in the 19th Century, it is possible that reserve currency status increases American employment and wealth creation. But in advanced economies productive investment is never constrained by lack of capital. It is almost always the case, in other words, that an increase in net foreign investment to the US (and to most advanced countries by the way) must result in some combination of a speculative investment boom, a consumption boom or a rise in unemployment. What typically happens is that in the beginning we get the first two, until debt levels become too high, after which we get the third.
6. Bryan Riley and William Wilson, two economists from the Heritage Foundation, in their response to Jared Bernstein’s article, provided their reasons in a blog entry last month for arguing that in principle the benefits of use of the dollar as the dominant reserve currency exceed the cost to the US of this higher debt or higher unemployment. Their piece was fairly short, and so I don’t want to suggest that I am representing the full scope of their disagreement, but they suggest that the benefits are:
Seignorage. The largest benefit has been “seignorage,” which means that foreigners must sell real goods and services or ownership of the real capital stock to add to their dollar reserve holdings.
Low Interest Rates. The U.S. has been able to run up huge debts denominated in its own currency at low interest rates. The dollar’s role as the world’s reserve currency reduces U.S. interest rates because foreign investors like to invest in the relatively safe U.S. economy.
Lower Transaction Costs. U.S. traders, borrowers, and lenders face lower transaction costs and foreign exchange risk when they can deal in their own currency. It’s easier to do business with people who take dollars.
Power and Prestige. The dollar’s dominant reserve status gives the United States political power and prestige. Britain’s loss of reserve-currency status in the 20th century coincided with its loss of political and military preeminence.
7. I think this is a pretty fair summary of the arguments generally used in favor of supporting “king dollar”, and I think they are worth addressing specifically. To address seniorage, the benefits of seniorage are really what the whole debate is about. If the US believes that it is important for the global trading system that the US produce enough reserves for a growing global economy, and if the global trading system benefits the US, it should do so. As long as the growth in global reserves is less than the growth in the US economy, the associated rise in debt is sustainable.
But, and this is the Triffin Dilemma, if reserves and other government accumulation of US assets grow faster than US GDP, seniorage results in an unsustainable increase in US debt (or unemployment). In my previous blog entry I argued that the former may have been the case in the 1950s, but as global GDP growth exceeds US GDP growth, as more countries and regions join in the global trading system, and as there is convergence between advanced and backward economies, the growth in US debt needed to capture these benefits either becomes unsustainable or, to restrain the growth in debt, requires a rise in US unemployment.
8. To address lower interest rates, I showed in my book why foreign purchases of US government bonds do not lower US interest rates. At best they simply distort the US yield curve and in the long term even raise them. I will not repeat the full explanation here, especially as there is a bit of circularity in the argument and counterargument: If the exorbitant burden causes unemployment to rise, as Austin and Bernstein argue, fiscal revenues must drop and fiscal expenses must rise, causing total government debt to rise by the same, or more (because most of us would agree that demand created by government spending is less efficient than demand created by trade) than the capital inflows available to fund government debt. So the additional supply of funding is only equal to or less than the additional demand for funding. But if you think unemployment doesn’t rise, as Riley and Wilson might argue (I am not sure if they do or don’t), then total debt doesn’t rise, or it doesn’t rise much, and the additional funding should cause interest rates to decline. In order to keep this short I would suggest simply that we consider the following.
The larger a country’s foreign current account deficit, by definition the greater the inflow of foreign money to purchase its assets, mainly government bonds in the case of the US and many other countries. The higher a country’s current account surplus, by definition the greater the outflow of money to purchase foreign assets, and the less domestic money available to purchase domestic assets. Is it reasonable, then, to assume that the larger a country’s current account deficit, the lower its interest rates, while the larger a country’s current account surplus, the higher its interest rates? This is what the low-interest-rate argument implies.
9. To address transaction costs, while it is true that trading in US dollars reduces transaction costs for American businesses, it is hard to believe that these transaction costs are not priced into the imports and exports of their foreign counterparts. More importantly, it is not clear that reducing central bank purchases of US government bonds will cause transaction costs to rise. The vast bulk of trading volume does not consist of central bank purchases of US government bonds. It is trade and investment related. If foreign central banks were limited in their ability to stockpile US dollar reserves, foreign exchange transaction costs would barely budge.
10. To address power and prestige, while it may be true that Britain’s loss of reserve-currency status in the 20th century coincided roughly with its loss of political and military preeminence, I think it is incorrect to imply that Britain lost power and prestige after the Great War mainly or even partly because sterling lost its status as the dominant reserve currency (which in fact really occurred some time in the 1930s and 1940s). It was the destruction, during the first two years of the Great War, of London’s role in trade finance (which formed the vast bulk of international lending at the time, with nearly the entire trade finance market moving to neutral Amsterdam and New York), followed by its aerial pounding in WW2, that caused London to lose its financial pre-eminence.
Even today it is hard to associate London’s current role as either the first or second most important financial center in the world, depending on how you measure it, with the status of sterling as a reserve currency. What is more, the US dollar only became the pre-eminent reserve currency in the 1930s and 1940s, but the US was the leading economic power – nominally, per capita, and technologically – by the 1870s. I would argue that US power and prestige probably has more to do with the size and dynamism of its economy, with the creativity of Hollywood and New York in entertainment and fashion, with technological innovation in San Francisco, Boston, New York, Austin, and elsewhere, with its composers and artists in New York, San Francisco, and elsewhere, with its overwhelming military superiority, with its universally-valued ideal of ethnic inclusiveness and individualism, with its Ivy League and elite universities, with its think tanks, with its astonishing scientists, and with a host of other factors more important than the currency denomination of central bank reserves.
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As Bernstein concluded,
what was once a privilege is now a burden, undermining job growth, pumping up budget and trade deficits and inflating financial bubbles. To get the American economy on track, the government needs to drop its commitment to maintaining the dollar’s reserve-currency status.
The sturm und drang is rising for the de-dollarization of the world... and maybe that's just what they want?