Be Careful What You Wish For
Jared Bernstein, former chief economist for Vice President Joe Biden, argues that it is time to “dethrone” the U.S. dollar. Bernstein bases his argument on new research by Treasury Department economist Kenneth Austin. According to Bernstein:
[T]he new research reveals that what was once a privilege is now a burden, undermining job growth, pumping up budget and trade deficits and inflating financial bubbles. To get the American economy on track, the government needs to drop its commitment to maintaining the dollar’s reserve-currency status.
Four Advantages of Reserve-Currency Status
There are a number of reasons to question Bernstein’s advice.
The United States does not have an official commitment to preserve the dollar’s reserve-currency status. The market, not policymakers, determined its reserve status. The global economy requires an adequate supply of assets that can be easily bought and sold at low transactions costs. U.S. Treasury bills and bonds have served this role for 60 years, providing the international financial system with the safety and liquidity it requires to function. This explains why more than 60 percent of foreign exchange reserves are held in dollar-denominated assets.
Some believe that it is now time for the dollar to lose its long reigning reserve status because the costs have come to outweigh the benefits. They should be careful what they wish for because the dollar’s reserve status has bestowed enormous benefits on the U.S. economy, some of which are not readily noticeable.
Seignorage. The largest benefit has been “seignorage,” which means that foreigners must sell real goods and services or ownership of the real capital stock to add to their dollar reserve holdings.
Low Interest Rates. The U.S. has been able to run up huge debts denominated in its own currency at low interest rates. The dollar’s role as the world’s reserve currency reduces U.S. interest rates because foreign investors like to invest in the relatively safe U.S. economy. While the U.S.’s ability to borrow at relatively low interest rates (or lower than they otherwise would be) has reduced pressure on Congress and the President to hammer out a long-term deficit reduction deal, deficit spending is not the fault of the dollar’s reserve-currency status, but of the government’s inability to reign in the growth in entitlement spending, particularly health care. In fact, higher interest rates could increase federal spending because more dollars would be needed to service the government’s debt.
Lower Transaction Costs. U.S. traders, borrowers, and lenders face lower transaction costs and foreign exchange risk when they can deal in their own currency. It’s easier to do business with people who take dollars.
Power and Prestige.The dollar’s dominant reserve status gives the United States political power and prestige. Britain’s loss of reserve-currency status in the 20th century coincided with its loss of political and military preeminence.
The Experiences of Other Countries
Bernstein states that dropping the dollar as a reserve currency would reduce the incentive for foreign central banks to accumulate dollars to weaken their own currencies, but no evidence indicates that a depreciating dollar would impact the trade deficit. Japan’s 25 percent depreciation of the yen in 2013 has not exactly resuscitated growth. Nor does this hold true with China, which accounts for two-thirds of the U.S. trade deficit. As Edward Lazear points out, the dollar–yuan exchange rate did not change from 1995 to 2005, but China’s exports to the U.S. increased sixfold at a rate of about 19.6 percent per year. Then, from 2005 to 2008, the yuan appreciated approximately 21 percent against the dollar. China’s stronger currency made its exports more expensive in dollars, so Chinese exports to the U.S. should have fallen. Instead, China’s exports to the U.S. continued increasing at about the same pace, averaging 18.2 percent per year.
While currency swings can affect relative prices and, in turn, trade balances, trade deficits are determined by the difference between domestic savings (private and public) and domestic “absorption” (consumption + government spending + investment). According to Atish Ghosh and Uma Ramakrishnan at the International Monetary Fund:
One point that the savings-investment balance approach underscores is that protectionist policies are unlikely to be of much use in improving the current account balance because there is no obvious connection between protectionism and savings or investment.
Bernstein writes, “It is widely recognized that various countries, including China, Singapore and South Korea, suppress the value of their currency relative to the dollar to boost their exports to the United States and reduce its exports to them.” It is also widely recognized that, whatever the motivation for devaluations, they impose costs on consumers in these countries by making them pay more for both domestically produced and imported goods.
Bernstein is also cavalier about inflation, which would rise given the dollar’s depreciation after losing reserve status, believing a higher rate is worth the cost of “saving jobs.” Yet higher inflation quickly erodes purchasing power. While 2 percent inflation (the current U.S. rate) erodes the purchasing power of the dollar by half every 36 years, 4 percent inflation would halve it every 18 years. That is a chunk of change.
In addition, no other global currency is ready to replace the U.S. dollar. A serious shortage of international liquidity would quickly kill the tepid global recovery and end globalization as we know it.
Regrettably, the dollar may be losing its role as the reserve currency, not as a result of a proactive agenda as recommended by Bernstein, but because of misguided U.S. economic policies. A majority of institutional investors surveyed earlier this year believed China’s renminbi will eventually replace the dollar as the world’s reserve currency. China itself has called for the creation of a new reserve currency. If the dollar ever loses its status as the world’s reserve currency, it is unlikely to benefit the United States, but instead it will be a costly sign of America’s decline.
Editor's Note: This piece was originally published by The Heritage Foundation.