Conspiracy theory notwithstanding, claims that the reserve status of the U.S. dollar unfairly benefits the U.S. are no longer true. On the contrary, it has become a burden, both for America and the world. [Let me explain.]
Reserve currency status is a global public good that comes with a cost [and] no currency [other than that of the U.S.] has the necessary characteristics to allow it, plausibly, to serve the needs of the global economy – and neither any other country, nor the EU, will be willing to pay the cost. If the U.S. dollar’s status is to decline in the future, it will require that Washington, itself, take the lead in forcing the world gradually to disengage [and,] ironically, that is exactly what Washington should be doing…
The Pros and Cons of Having the Dollar as the Reserve Currency
During the first few decades of the post-war period, the cost of maintaining the dollar’s status could be justified by the incremental benefits to the U.S. of a stable and growing world economy, within cold war constraints. Beginning in the 1980s, [however,] trade policies abroad have sharply raised the cost to the U.S. while the end of the cold war has limited the benefits.
The cost [to the U.S.] comes as a choice between rising unemployment and rising debt. The mechanism is fairly straightforward. Countries that seek to supercharge domestic growth by acquiring a larger share of global demand can do so by gaming the global system and actively stockpiling foreign currency, mainly in the form of, but not limited to, central bank reserves.
In practice, dollar liquidity, limited Washington intervention, and the size and flexibility of US financial markets ensure that countries (such as China) stockpile dollars. There is no alternative, and most other governments would discourage substantial purchases of their own currencies. [This] foreign acquisition of dollars, [however,] automatically forces the U.S. into running a corresponding current account deficit. Active trade intervention abroad, in other words, is accommodated by rising trade deficits in the U.S.. This importing of US demand by other countries forces the U.S. economy to respond in one of two ways:
- American unemployment must rise as demand is diverted abroad, or
- Americans must counteract the employment impact by increasing domestic consumption or investment.
Without government intervention, there is no reason for domestic investment to rise in response to policies abroad. On the contrary, with the diversion of domestic demand private investment may even decline. [As such,] in order to limit the impact on jobs, capital flows into the U.S. must finance additional US consumption. Americans, in other words, must choose between higher unemployment and higher debt. In the past the Federal Reserve has chosen to encourage higher debt.
The Benefits to the U.S. of Reserve Currency Status
Analysts argue that the predominance of the dollar [benefits] the U.S. in two ways:
- reduced cost of imports and
- lower government borrowing costs.
Both arguments are flawed.[In the first case,] Americans over-consume and don’t need lower consumption costs, especially at the expense of employment. [Furthermore,] if cheaper consumption is really such a gift, it is hard to explain why attempts by the U.S. to return the gift – by demanding that foreigners revalue their currencies and so reduce costs for their own consumers – are always so indignantly rejected. [In the second case,] creditworthiness matters more than currency status. Reserve status increases US borrowing, and thus undermines the ability of the U.S. Treasury to finance itself cheaply more than would losing reserve status.
The large imbalances that the U.S. dollar foreign reserve system has permitted now destabilise the world. If forced to give up the dollar the world might see global trade reduced somewhat, and it would probably spell the end of the Asian growth model. [On the other hand,] it would also lower long-term costs for the U.S., and reduce dangerous global imbalances.
The U.S. should, therefore, take the lead in shifting to multi-currency reserves, in which the dollar is simply first among equals.
The comments above are edited ([ ]) and abridged (…) excerpts from the original article by Michael Pettis
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