The idea is simple: As the United States turns more protectionist, other countries are stepping into the breach and making trade deals that leave us out. Could this process lead to the U.S. dollar no longer reigning supreme as the dominant currency in global commerce?
The article concludes that this is a worrisome possibility. Central banks and currency investors are already “ramping up investment in such currencies as the euro and Chinese yuan, reflecting the effects of such moves as the U.S. retreat from the North American Free Trade Agreement and Trans-Pacific Partnership.”
But how worrisome is the dethroning of King Dollar? A vocal minority, among which I count myself, believes that what was once an exorbitant privilege has become a cumbersome burden.
Like everything else in economics (and life), there’s a trade-off. Having our currency be the premier reserve currency — the one that countries most want to hold to transact business and protect against shocks — has benefits and costs (dollar reserves are about 63 percent of global reserve holdings). The thing is, the benefits are no longer so beneficial, and the costs have gotten too costly.
The privileges of the reserve issuer have been twofold. First, they allowed us to run large, persistent trade deficits. This is partly a function of international accounting: When other nations buy dollars, our capital account (capital inflows from abroad) goes up, and our current account (trade deficit) goes down (it gets more negative). In fact, since the mid-1970s, countries have lent us whatever we need to consume more than we produce, meaning we have run trade deficits every year. (For the most recent quarter, the trade deficit was over $600 billion, or 3 percent of GDP.)
Of course, if you’re thinking that four decades of trade deficits are a mixed blessing/privilege, I’m with you, but more on that in a moment.
Second, being the premier reserve issuer means that other countries are happy to buy your debt — corporate, public and private. Moreover, assets in the reserve currency carry an inherent premium in international finance, which means we don’t have to pay creditors as much for their loans as we otherwise would, i.e., the reserve issuer has lower interest rates.
But both privileges carry costs. Inward capital flows strengthen the dollar, which makes our exports more expensive and our imports cheaper. As international trade expert Joe Gagnon wrote a few years ago, other countries “send capital abroad to push down the values of their currencies in order to boost exports and economic growth. Official purchases of foreign exchange reserves and other foreign assets — mainly U.S. dollars — have exploded since 2000 to unprecedented levels as a share of global GDP.”
This may sound obscure, but it’s actually simple accounting with serious consequences. When countries that are “currency accumulators” save more and consume less than they produce, “currency issuers” — that’s us — must balance the global accounts by saving less and consuming more than we produce.
In other words, this is no morality tale of profligate Americans compared to thrifty Chinese or Germans. 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. The dollar’s reserve status is a key factor behind these dynamics.
But what could be wrong with the second privilege: cheap borrowing? Nothing, if there are lots of productive investments to be made. But if that’s not the case, the excessive, cheap capital just gets funneled into dot-com bubbles, housing bubbles and budget deficits.
Speaking of budget deficits, as you know, ours is going up, thanks to the deficit-financed tax cut and recent spending bill. Much of the deficit’s financing will derive from precisely these dollar dynamics. In fact, there’s a good chance that the trade deficit will further deepen over the next couple of years, as the economy closes in on full capacity with all this fiscal stimulus in the pipeline.
That is, we tend to think that economic overheating shows up as inflation, and that’s true, but, as Brad Setser points out, a higher trade deficit is another absorption mechanism for excess demand. If so, it means the tax cut is stimulating foreign, not U.S. demand, and I can think of an orange president who won’t like that one bit.
Okay, that last bit is speculation, but I’m confident in asserting my main conclusion: If one consequence of the Trump era is that the dollar loses some degree of its reserve status, I will consider that a good thing. To be very clear, if that occurs because of Trumpian protectionism, reckless fiscal policy and government dysfunction, all of which discredits the dollar, I’ll of course be arguing that that’s a terrible path to lowering our reserve status. That’s the source of the parenthetical “sort of” in the title to this post.
But even if that’s the path, the fact will remain that this privilege is now more of a burden, one we should be happy to shed.