Reserve Currency Temptations

June 7, 2011

The country whose currency anchors the international monetary system has unique advantages in raising capital.  Because It can borrow overseas in its own money, the real burden of foreign-held debt doesn’t increase if its currency depreciates.  This benefit of reserve asset hegemony tends to depress interest rates and promote economic growth, and it encourages monetary and fiscal policymakers to act less responsibly than their counterparts in other countries for whom currency depreciation has greater and more direct negative economic consequences.  The policymakers of the world’s dominant reserve currency merely have to guard against squandering that leadership status.  In the first half of the twentieth century, this happened to Britain, as the baton was passed to the United States.

However, the United States does not face a serious near-term threat of being dethroned as the dominant reserve currency economy.  The United States still has the deepest and most liquid market for government securities.  The dollar’s most plausible challenger is the euro, whose domestic markets are also extensive and quite liquid and whose population is even greater than America’s.  Nonetheless, economic union hasn’t developed in lockstep with the twelve-year experience of monetary union in Europe, and the legitimacy of the euro remains compromised by the risks of a debt default or departure of one or more of its participating members.  Dollars exceed euros in reserve asset portfolios by a ratio of more than 2.25 to 1.0.

Other potential reserve asset successors to the dollar are also flawed.  Japanese economic growth of about 1% per annum over the last twenty years rules out the yen.  China’s yuan is highly managed.  It is not fully convertible and is subject to regulations that limit the depth and liquidity of Chinese capital and money markets.  In spite of three decades of very rapid development, China still resembles an emerging economy based on many key gauges such as per capita income.  India, too, hasn’t attained the status of a full-fledged advanced economy.  Synthetic currencies like the SDR have never gained the kind of widespread acceptance required of a reserve currency.  They do not meet the basic condition that a reserve currency needs to embody an asset that people can readily hold.

The temptations to neglect the value of a reserve currency are great.  It’s not a coincidence that the dollar, like the previous dominant reserve currency, the British pound, has often been neglected even in times of weakness.  The United States is said to be governed by laws, not people, but people design and implement the laws.  It is human to exploit natural advantages, such as the seemingly “free lunch” of a depreciating currency.

Since touching a cyclical high of 1.1878 per euro exactly one year ago today, the dollar has declined roughly 19% against its chief rival.  The greenback is also 30% and 12.5% weaker than a year ago against the Swiss franc and yen, and it has lost 13.5% in trade-weighted terms.  During the past ten years, the dollar has fallen 55% against the Swissy, 33% against the yen, 43% relative to the euro, and 42% in trade-weighted terms.  Depreciation since June 2010 is an extension of on-and-off but mostly on-again weakness. 

It is a fair question to ask how dollar depreciation has penalized the United States, and the answer policymakers observe is “not much.”  The growth of U.S. real GDP and employment, to be sure, has been considerably weaker since Y2K than in the second half of the 20th century, but the United States continues to command an edge on these criteria vis-a-vis Japan and Europe.  The United States experienced a shallower Great Recession than Europe or Japan, and the consensus view of economists puts U.S. growth at almost 3% in 2011-12 compared to less than 2% for Euroland and Great Britain and around 1.5% in Japan.  U.S. core inflation averaged a benign 1.7% per annum over the past five years, and total U.S. CPI inflation in 2011 and 2012 is expected to be very similar to what Euroland will experience.  The current ten-year Treasury yield of 3.04% is 105 basis points less than its ten-year average and 5 basis points below the current 10-year German bund yield.  A U.S. current account deficit that still exceeds 3% of GDP is being easily financed, and that equilibrium has coexisted with a downwardly trending dollar.

Back in late 2010, many analysts were anticipating a strong year for the dollar, and several developments could have made such forecasts look prescient.  Europe’s debt woes continue to threaten the euro and European banks.  The end of QE2 is just around the corner.  Symptomatic of rising risk aversion, global stocks have appeared more fragile since end-April when the DOW closed above 12,800.  Japan experienced a devastating earthquake.  Bin Laden was killed, and oil prices have plateaued. 

And yet, the dollar’s karma has stayed poor.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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