The dollar’s role as the world’s primary reserve currency helps all of us Americans by keeping interest rates low. Foreign countries buy United States Treasury debt not just as an investment, but because dollar-denominated assets are the best way to hold foreign exchange reserves.
This topic is on the minds of American small business owners I learned last week speaking to hundreds of store owners at an Ace Hardware conference. I was surprised by how many people button-holed me to chat on the subject.
China may have prompted some interest in the subject: “. . . it is perhaps a good time for the befuddled world to start considering building a de-Americanized world,” wrote Liu Chang for China’s official news agency Xinhua. With our recent budget crisis, debt ceiling crisis and the 2011 credit rating downgrade, United States finances look shaky. Let’s figure out what the reserve currency status means, why it will continue to a large extent, and how the related issues influence the future.
I was recently invited to give a talk in China on the topic of reserve currency status for the Chinese currency, the Reminbi or Yuan. I had to decline, but the invitation got me thinking about what I might have said in such a speech. The predominate thought that came to mind was probably not what the Chinese would want to hear, which was, watch what you pray for.
The advantages of reserve currency status for the dollar are well known. The world’s willingness to accumulate dollar reserves in the post World War II period first removed and later reduced the requirement of maintaining balance of payments equilibrium, or, more specifically, current account balance. By removing or weakening this restraint, U.S. policymakers had more freedom than policymakers in other countries to pursue strictly domestic objectives. We ran current account deficits year after year, balanced, or paid for, by capital inflows from our trading partners. The good side of that was that we could import real goods and services for domestic consumption or absorption and pay for them with paper, or the electronic equivalent. In other words, our contemporary standard of living was enhanced by others’ willingness to hold our currency without “cashing it in” for goods and services, or, before 1971, gold.
The bad side of our reserve currency status, although seldom recognized, was that the very leeway that enhanced our current standard of living built up debt (and/or reduced foreign assets) to dangerous levels. I remember well when, in 1985, the United States ceased being a net creditor nation to the rest of the world and, instead, became a net debtor nation. Our net indebtedness has only grown over the years, and hangs over us like the legendary sword of Damocles.
China has since 1994 operated some form of currency peg, harder or softer, between its yuan and the U.S. dollar. While China’s state-run Xinhua news agency has in recent years railed against U.S. management of the dollar, and has called for “a new, stable, and secured global reserve currency,” this week’s Geo-Graphic illustrates why China has little incentive to press for such a thing.
During the 1956 Suez crisis the Eisenhower administration threatened to create a sterling crisis in order to force Britain out of Egypt. A collapse in sterling would have caused minimal collateral financial damage in the United States owing to trivial U.S. government holdings of British securities – amounting to just $1 per U.S. resident. In contrast, China’s holdings of U.S. securities today amount to over $1,000 per Chinese resident. Any major fall in demand for dollar-denominated assets would cause a collapse in the global purchasing power of China’s massive dollar hoard.
Davos-Klosters, Switzerland, 26 January 2013 - China's currency, the renminbi (RMB), will probably not supplant the US dollar as the world's reserve currency, except possibly "in the very long term", said Lawrence H. Summers, Charles W. Eliot University Professor, Harvard University, and a former US Treasury Secretary, in a televised session at the World Economic Forum Annual Meeting today.
While the RMB will continue to internationalize, "the centrality of the dollar is unlikely to change in a major way," Summers said, adding, "just as there is a basic inertia in languages of communication, there's a basic inertia in mediums of exchange."
John Zhao, the Chief Executive Officer, Hony Capital, however, expects freer exchange of the RMB "will come much sooner than most of us expect." He cited the Chairman of China's Communist Party Xi Jinping's recent trip to Shenzhen, during which he visited Qianhai, a special zone set up for experimentation in RMB internationalization, as a sign of China's intent to globalize its currency.
Summer also spoke of "the reality that China holds some trillions of dollars of liquid financial assets around the world, on which it is earning an extremely low rate of return, while at the same time there are important shortages of investments in key sectors of the world". Huge amounts of capital flowing from poorer countries to richer countries is "unprecedented territory", he said, and will require important deliberations.
The panellists discussed how an ascendant China needs to communicate its intentions to the world. China's world power status arrived decades earlier than expected. "It has been a bigger surprise to China than probably to the rest of the world," said Kevin Rudd, Member of Parliament, Australia, and a former prime minister of that country. He cited a speech given by Xi, in which he spoke of China's "rejuvenation", and the lack of clarity of what that means. China has benefitted from an international rules-based order; the international community "would like to know soon if [China] would like to make changes to the rules," he said.
Gordon Brown, the UN Special Envoy for Global Education, and Prime Minister of the United Kingdom (2007-2010), said that the rise of China is taking place in an interconnected world, a "totally different context than any other power in any other century". He urged international communication among China and other countries.
No less an authority than Goldman Sachs CEO Lloyd Blankfein said at the Clinton Global Initiative last week that the United States could risk its status as the world's reserve currency if congress fails to act and the "fiscal cliff" program of spending cuts and tax increases is enacted January 1.
Actually Blankfein's statement was the reverse of the truth; enaction of the "fiscal cliff" program, halving the US budget deficit at a stroke, is one of the few outcomes that could AVOID the US losing its reserve currency status. But on the assumption that thepoliticians continue to misbehave after November 6, that trillion-dollar deficits continue, and the US does indeed over time lose its reserve currency status, what will a world without a reserve currency look like?
There is no relatively recent historical parallel we can examine to answer that question. The world has had the dollar as undisputed reserve currency since 1945, or really since 1939. Between 1914 and 1939 there were two reserve currencies, the dollar and sterling, with sterling more used in the 1930s than the 1920s, because that decade, once Britain went off the Gold Standard, was a period of robust health for the British economy, while the United States was mired in depression and isolationism. For more than a century before 1914, the world's undisputed reserve currency was sterling, although there were various regional alternatives.
To see a world with multiple reserve currencies, you thus need to go back to a world before sterling's sway, which in practice means before Britain's smashing victory in the Seven Years War (1756-63) took it to both military and economic supremacy.