US economic policy shot in the foot #2: An exorbitant privilege squandered

As RebelEconomist was asked by a commenter on his previous post (about the ascendancy of the euro as a reserve currency) to expand on his remark that America could have handled the reserve status of the dollar better, it is opportune to post the second in his trilogy of criticisms of US economic policy in recent years, which happens to concern that issue.

Although it is easy to get a different impression from reading some US macroeconomic commentary, having a reserve currency gives a country like the USA a potential economic advantage. Indeed, to the countries that feel obliged to hold reserve currencies without their own currency being equally held by other countries, issuing a reserve currency seems like an “exorbitant privilege” as Valéry Giscard d’Estaing (not Charles DeGaulle, to whom I mistakenly attributed the quote before) described the US dollar. The key advantage of having a reserve currency is that the country can borrow in its own currency at a relatively low interest rate, because the demand for interest-bearing reserve assets from other countries drives down its interest rates, especially on the government debt in which foreign currency reserves are typically invested. In fact, after allowing for expected exchange rate movements, a reserve currency issuer can normally pay less on its domestic currency liabilities than it receives on its own foreign currency assets (see for example, Gourinchas and Rey, 2005). A reserve currency issuer also has the option to create an excessive amount of money to reduce the real value of its outstanding debt and help finance its government, but exercising this option is likely to deplete its reserve currency status.

So why do some US analysts complain about the accumulation of dollar reserves by foreign countries? Mainly because the reserves accumulation has been a consequence of foreign countries' intervention, particularly by East Asian and Gulf Cooperation Council (GCC) nations, to stop their own currencies appreciating against the dollar. By implication, this has kept the dollar stronger than otherwise and thereby at least contributed to an unwelcome US trade deficit and the decline of some US industry. A more controversial complaint, which RebelEconomist will question in a future post, is that the reduction in US treasury yields caused by the investment of the intervention proceeds, famously characterised by Ben Bernanke as a "saving glut" fostered a market for riskier alternative investments which contributed to excessive housing construction and the sub-prime crisis. It is also argued that the currency policies of countries like China hurt their own people, but for the purposes of this post, let us take their choice as a given and focus on how the US can make the best of it.

A link between reserves accumulation and reserve currency appreciation leading to industrial decline is plausible. It is like the problem of "Dutch disease" faced by countries enjoying a surge in income from the exploitation of a natural resource, named after the impact of a natural gas boom on the Dutch economy in the 1960s and 70s. In brief, Dutch disease develops as the increased spending of the resource owner in their national economy drives up the prices of non-traded items such as labour, while the prices of tradable items like manufactured goods are fixed by international competition. An overall rise in domestic prices relative to foreign prices represents an appreciation of the real exchange rate, and assuming fixed money stock, the increased transactions demand for money as the economy expands to include resource exploitation activity drives up the exchange value of the domestic currency, meaning an appreciation of the nominal exchange rate too. Domestic producers of tradable items that use non-tradable inputs face higher costs than their foreign competitors, and being unable to raise their prices, are forced to contract, meaning that some of the resource windfall can end up paying for increased unemployment.

It is understandable that reserves accumulation can produce an effect like Dutch disease as it effectively transfers real resources to the sellers of the reserve currency debt in which the intervention proceeds are invested. To coin a phrase, the US economy is suffering a bout of “American ague”. In fact, American ague is a more serious ailment, because the resources that flow into the reserve currency economy do not represent unencumbered wealth like a natural resource windfall; they oblige the debtor to pay back resources in the future. If the reserve currency country fails to prepare for this eventuality, it may come as a nasty shock. Given their similar mechanisms, could the treatments that have been applied for Dutch disease work for American ague?

There are two standard treatments for Dutch disease. One is to intervene in the foreign exchange market against the appreciation of the domestic currency, selling domestic for foreign currency to absorb the additional inflow from resource exports. In most cases, the government already receives the domestic currency needed for this purpose through state-owned resource producers and/or from royalties on resource sales, but if not, the government should be able to increase taxes on the private sector to tap the export boom. In fact, if the resource exports and associated taxes are payable in foreign currency, the government can purchase foreign assets directly without intervention. Besides immunising the economy against Dutch disease, buying foreign currency assets spreads the benefits of the export boom into the future, perhaps permanently, which enhances national welfare if the marginal utility of consumption is declining. Where foreign currency assets are acquired by intervention, they are typically included in the country’s foreign exchange reserves managed by the central bank, but they can equally well be entrusted to the care of a specialist sovereign wealth fund (SWF) management institution, as in Norway for example. The other remedy for Dutch disease is to use the export revenue to import capital goods, and if necessary foreign labour too, to invest in the domestic economy like the GCC countries do. The government can build infrastructure such as roads, railways, electricity supply, schools etc that can be expected to yield future dividends, including to the government itself in the form of enhanced taxes. Alternatively, the government can buy stakes in domestic enterprises or use tax breaks to encourage investment by the private sector.

To adapt these treatments for American ague, in the absence of a resource windfall, the authorities need another source of domestic currency to fund their investment in foreign exchange reserves or public infrastructure. The obvious answer is to sell more government debt into the demand from foreign reserves managers. Provided that these debt sales do not eliminate the price premium on reserve assets, it should be possible to realise the exorbitant privilege as the risk-adjusted spread between the outlay on servicing government debt and the income from reserves or infrastructure assets. Such asset-liability matching also prudently sets aside the funds required to repay the government debt when due.

Obviously, the US government did not adopt such policies. Dollar reserve accumulation accelerated first as Asian countries built their foreign exchange reserves following the Asia crisis of 1997, and then as rising oil prices in the last five years or so boosted the incomes of oil producing countries. In the meantime, the US Treasury was actually buying back its debt from 2000 to 2002, while the Federal Reserve continued to steadily accumulate treasuries until recently to back its base money. Apart from a couple of symbolic interventions in coordination with other central banks (in support of the yen in June 1998 and the euro in September 2000), the US authorities have not intervened in the foreign exchange markets since 1995. The proportion of US GDP accounted for by government activity, including investment, is low compared with other countries. US economic policy did not change in response to the reserves inflows. The result was that foreign countries’ purchases of treasuries reduced the supply available to other investors and lowered treasury yields, “crowding in” other kinds of debt and reducing US saving. Reserve inflows have therefore effectively financed increased consumption and the US net international investment position (NIIP) has become increasingly negative. Collectively, America has behaved as if the exorbitant privilege was not the cost of funds, but the funds themselves. The exorbitant privilege has been squandered.

Why were remedies like those for Dutch disease not tried by the US authorities? It was certainly not because there was a lack of opportunities for investment in US foreign exchange reserves or public infrastructure.

Judged against the yardsticks that the US Treasury uses to measure the reserves adequacy of other countries, America's foreign exchange reserves are unequivocally inadequate. A paper by the US Treasury Office of International Affairs suggests that countries should hold reserves sufficient to pay for three months’ worth of imports, 100% of short-term external foreign currency debt (a minimal interpretation; the paper does not specifically exclude domestic currency debt, which accounts for most US external debt), or 5% of M2 money stock (again, a minimal interpretation; a range of 5-20% is mentioned) depending on the type of emergency that is most likely to generate a call on their reserves. The present holding of $277bn worth of US foreign exchange reserves (including gold, which accounts for 82%) provides 22%, 97% and 72% of the suggested cover respectively. It could be argued that US currency intervention would not have been welcomed by the Eurozone and Japan, in whose currencies America exclusively holds its foreign exchange reserves at the moment. Perhaps so, but these countries should accept that official inflows are a corollary of the international role they have actively promoted for their currencies. And there were occasions when more substantial US intervention in support of their currencies would have probably been welcome, by the Eurozone in Autumn 2000, and Japan in Spring 1998 (maybe June 2007 too). To reduce the impact of such reserves accumulation, the US could have broadened the range of currencies it holds in its reserves to include sterling and Canadian dollars for example, and added other instruments such as equities. America could have even created its own SWF.

It also appears that the US government could usefully invest more in public projects (unless the invasion of Iraq is regarded as an investment in energy security). To European and Japanese visitors, the poor state of US public transport is striking; few major airports have a railway connection to the centre of the city they serve. The tragic consequences of inadequate levees near New Orleans and a decaying bridge in Minnesota show how worthwhile some infrastructure projects might have been. The American Society of Civil Engineers 2005 report card assessed the condition and capacity of US infrastructure as grade D, and estimated that expenditure of $1.6tn was needed to bring it up to scratch.

Nor has the US government been constrained from issuing more treasuries by the size of the government debt. By European, let alone Japanese, standards the US net government debt to GDP ratio of 31% (or 60% including debt assigned to the social security trust fund) is relatively low.

No doubt the main reason why the US government has not increased its borrowing and investment in foreign exchange reserves and public infrastructure to absorb official capital inflows is that both policies would conflict with Americans' traditional aversion to, in the case of intervention, interfering in financial markets, and, in the case of investing in public infrastructure, taxing and spending and "big government". Regrettably, now that a rise in US long-term interest rates would be hard to bear, and now that the dollar has depreciated and the dollar pegs of some of the largest reserves-accumulating countries are showing signs of strain, it is probably too late for the US to change its approach to dealing with official capital inflows. If the euro does succeed the dollar as the world’s principal reserve currency, however, the Europeans would presumably not be restrained by such views from using official capital inflows for public investment. Perhaps a dedicated EU institution could be established to isolate and manage the exorbitant privilege, by both issuing euro debt designed to appeal to reserves managers and acquiring a range of broadly liability-matching investments from non-euro financial assets to European public infrastructure projects.