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
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
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
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
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
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
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