Forty years ago, Treasury Secretary John Connally told U.S. allies: “The dollar is our currency, but it’s your problem.” That high-handed attitude grated, but it was an accurate reflection of the economic dominance of the United States.
Today, as U.S. political dysfunction threatens the world economy, we seem to take the same approach. Consideration of how the economic forces unleashed by domestic U.S. politics doesn’t loom large in the decision-making of any U.S. elected official.
That motivates foreigners to carp about the irresponsibility of the U.S. This week Chinese leaders fumed, with some pointed suggestions that it is time for the rest of the world to adopt another currency to replace the U.S. dollar as the instrument used to make most international payments and in which to hold their foreign exchange reserves. These suggestions have caused some alarm among U.S. pundits. But is this really justified?
Former French President Valery Giscard d’Estaing argued that the dollar’s reserve currency role accorded our country an “exorbitant privilege.” Many Americans agree, without being able to articulate why, though some cite as important the fact that crude oil is priced in dollars in international trade.
There are concrete advantages to having the world’s reserve currency. The first is “seigniorage,” or the difference between the value of money and the cost of producing it. To the extent that the Federal Reserve can create a part of the money supply — currency or bank deposits — that are held outside of the country, this is an interest-free loan from the rest of the world to the U.S. Treasury. The dollar value of that varies with actual interest rates the Treasury must pay, but often is estimated at about $10 billion per year.
It’s also to our advantage that we can borrow abroad in our own currency. That isn’t limited to the most important currency. The Netherlands could borrow in guilders right up until the euro was introduced, and New Zealand or Switzerland can easily find buyers for bonds issued in their currencies. But it does benefit us.
Willingness to lend money to a nation in its own currency ultimately depends on trust that it will not abuse that privilege with policies that lead to inflation or to deterioration of the value of its currency relative to others. Being the global reserve currency certainly makes dollar-denominated bonds more desirable, the market for them much more liquid and hence the interest rate needed to sell them lower. It’s estimated to save the Treasury $50 billion to $100 billion per year.
On the other hand, being a reserve currency means that more foreigners want to hold some of it and that drives up demand for it. The result is that our currency has a higher value related to other currencies than it would have otherwise. Some estimates are that the value of the dollar is 5 percent to 10 percent higher against other currencies as a result.
This makes imports from other countries less expensive by that same percentage and our exports to other countries more expensive. This is good for consumers but bad for producers and employment. One estimate is that this means about $50 billion in lower gross domestic product.
That brings us back to China. China reportedly holds about $3.3 trillion in the currencies of other countries, some 60 percent in U.S. dollars and the rest in euros, pounds, yen and other monies. Most of the dollars are held in U.S. Treasury bonds or “agency securities” from Fannie Mae and so forth. That is why they become nervous about any hint that the U.S. Treasury won’t be able to pay principal or interest on its bonds.
But they are not holding some $2 trillion in dollars simply to help us out. They acquired these dollars as a way to keep the value of the dollar up and that of their yuan down, precisely to increase their exports to us and decrease their imports. This has the effect of favoring Chinese producers and employment to the detriment of Chinese consumers.
If the Chinese think the world would be better off with a different reserve currency substituting for the U.S. dollar, they could take some simple steps to promote their own.
They would need to stop trying to control the value of the yuan against the dollar and instead let its exchange value float with market forces against all other currencies. They would need to remove all controls on flows of capital into and out of China. They would need to reassure foreign investors that bonds issued by the Beijing government, or by the many financial institutions and industries directly controlled by the Communist regime, will be just as safe and liquid as those issued by the U.S. or British governments.
The first two could be done quickly, the last would take decades. But doing so would require an enormous U-turn in policies the Chinese government has pursued for 30 years. And the latter ultimately would require the regime to surrender its philosophical core — that of the Communist Party as the director of China’s economy and society. Don’t expect that to happen in anything but the long term.
All that said, the fact that neither the yuan or euro are in a position to displace the U.S. dollar as the world’s reserve currency is weak praise for the dollar. Our Congress is inflicting great damage on the U.S. and world economies right now. This is happening whether or not a “default” happened and regardless of whatever short-term fiscal kick-the-can deal emerges.
In economic declines of nations, whimpers are much more common than bangs.
We are doing much better than Europe right now in terms of emerging from the financial crisis and recession. And we were in an enviable fiscal position at the end of the last century, with a tenuously balanced budget and a decade before the Baby Boomers began to retire. But we threw that chance away and our current relative prosperity is shaky.
We need to have some basic consensus on a realistic balance of taxes and spending that is sustainable over the long term. That involves running surpluses during good times and deficits during bad ones. There is no time in the seven decades since World War II when we have been further from that consensus.