You have to hand it to Ben Bernanke, he can bring together people from across the political spectrum. In response to the Fed’s aggressive creation of new bank reserves over the past three years, Chinese communists and French conservatives join in moaning about the United States’ abuse of the dollar’s dominant status as a ‘reserve currency.’
Their beef stems from the fact that most nations of the world are forced, at least in practical terms, to keep large sums of some larger nation’s currency or risk economic chaos. For more than a century, the British pound sterling served that function. For the past 70 years, however, the U.S. dollar has dominated. This dependency makes those nations vulnerable when the U.S. central bank increases the money supply, thus decreasing the value of the dollar compared with other currencies and perhaps cutting the buying power of the dollar domestically as well.
The practical effect is that the United States can export to the rest of the world part of the effects of its large budget deficits and of unprecedented increases of the bank reserves that underlie its money supply. Those other countries feel abused. Leaders in China, France and Brazil are particularly voluble right now.
To understand the whole kerfuffle, one needs to understand two terms: “seigniorage” and “reserve currency.”
In the Middle Ages, seigniorage was the gain enjoyed by whatever lord had a monopoly over minting coins. If a royal mint could spend 950 francs buying silver bullion and then turn that bullion into 1,000 new franc coins, the 50-franc gain was “seigniorage.” The lord had an extra 50 francs to spend that did not have to be earned, borrowed or overtly taxed from the public.
With paper money, the process is similar. A government spends money, financed by selling bonds. But it is the nation’s central bank that buys the bonds, paying for them with money created out of nothing. The government spends money without taxing or borrowing from the public.
In both situations, there are limits to how much seigniorage a government can realize without causing inflation or other problems.
A “reserve currency” is the money of one nation of which other nations choose to hold in large amounts as “foreign exchange reserves.” The reasons for doing so are unfamiliar to many Americans because we are the major exception to the rule.
Nations that need to import goods or services, that need to make debt payments to other countries or that have sundry other international financial relationships know they should own substantial quantities of some foreign currency that is accepted everywhere, that is safe from political or economic turmoil, that holds its purchasing value and with which one also can buy bonds or stocks in markets that are stable and liquid.
If a country doesn’t maintain such reserves and an economic squall comes along, as in Asia in 1997 or Argentina in 2002, it may not be able to pay for the oil or food it needs. It may not be able to make promised principal and interest payments when due. All this can cause grievous harm to its economy.
The need of other countries to maintain such reserves benefits the country whose currency is used as a reserve. First, it expands the amount of seigniorage. Within the country itself, the amount of new money a central bank can create is limited by the public’s willingness to hold and use it. Create too much money and you get inflation.
But if other countries also are willing to hold your money, you can create more without raising domestic prices. The government can issue more bonds that are bought by the central bank with newly created money. At its most basic, foreigners willing to hold dollar balances are giving our government money to spend.
It gets more complicated, however. Foreign governments don’t want to pile up physical dollar bills. They prefer to earn interest. So they buy dollar-denominated bonds or other financial assets. These may be Treasury bonds, corporate bonds, state and local bonds or even “agency” securities issued by entities like Fannie Mae.
Thus, being the country whose currency is preferred by other nations wanting to hold reserves means more money is offered to buy government or private bonds than would be the case otherwise. (“Preferred” often means “the least bad alternative.”) Interest rates are lower and budget deficits can be higher without driving up interest rates.
It all works fine as long as the nation whose currency serves as a reserve is prudent and does not abuse its position by increasing its money supply too much. But a position of economic predominance fosters arrogance. And fear stemming from a financial crisis caused by bad policies fosters disregard for collateral damage to others.
Other countries, particularly China, are far from innocent victims in all of this. But the Fed’s aggressive actions over the past three years have injected great liquidity into global financial markets, even if they have not yet caused consumer inflation in our own country or even dramatic increases in our money supply. That extra liquidity is causing problems and other nations’ resentments have some justification even if the complainers are not without sin themselves.
History shows nations that abuse their position as issuers of a reserve currency lose that special status in the long run. But for a variety of reasons, the dollar will remain the least bad alternative for some time.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.