Dangerous Dollar Dependence

With US Federal Reserve chairmanwarning about inflation, the US dollar is in the news these days, and there’sa sense that the world economy has become excessively reliant on the dollar.This reliance smacks of dysfunctional co-dependence whereby the US and the restof the world both rely on the dollar’s strength, but neither is well served byit.

The US dollar is the world’spremiere currency, with approximately two thirds of world officialforeign-exchange holdings being dollars. Moreover, many countries appear willingto run sustained trade surpluses with the US, supplying everything from t-shirtsto Porsches in return for additional dollar holdings. This willingness toexchange valuable resources for paper IOUs represents a form of dollar tribute.

Many foreign policymakerscomplain about the special advantage for the US, allowing the nation to runenormous trade deficits without apparent market sanction. Whereasbalance-of-payments considerations constrain other countries to run tighteconomic policies, no equivalent constraint appears to hold for the US. Thisadvantage is rooted in the dollar’s special role as the world’s reservecurrency.

For the US, one major benefit ofthe dollar’s reserve-currency role is that it increases the demand for USfinancial assets. This drives up prices of stocks and bonds and lowers interestrates, thereby increasing household wealth and lowering the cost of borrowingmoney. Additionally, the US government gets seignorage, or an interest-freeloan, from the hundreds of millions in dollar bills held offshore. Printing a$100 bill is almost costless to the US government, but foreigners must give morethan $100 of resources to get the bill. That’s a tidy profit for US taxpayers.

Increased foreign demand for USassets also appreciates the dollar, which is a mixed blessing. On one hand,consumers benefit from lower import prices. On the other, it makes USmanufacturing less competitive internationally because an overvalued dollarmakes US exports more expensive and imports cheaper. Reserve-currency statustherefore promotes trade deficits and de-industrialization.

The conventional explanation ofthe dollar’s reserve-currency status is a "medium of exchange" story. TheUS has historically been the largest and richest currency area, with the largestshare of world output and trade. This has provided incentives for othercountries to hold and use dollars. Additionally, the fact that many governmentsover-issue their own money and create high inflation encourages foreign citizensto protect themselves by holding dollars instead of domestic currency.

A second theory of reservecurrencies, associated with the political left, is based on US military powerand the Pax Americana. The argument is that US military power provides thesecurity that protects the global market system, and New York is the new Rome.Countries, such as Saudi Arabia, hold reserves in dollars because New York is apolitical safe haven and because that helps cover the costs of enforcing the PaxAmericana.

These two theories are mutuallyreinforcing. Thus, to the extent that the dollar is widely used and is also asafe haven, investors tend to rush into dollars in times of uncertainty.Consequently, central banks in other countries need to accumulate largedollar-reserve holdings to protect against financial disruptions that resultfrom sudden exits by investors, as happened in East Asia in 1997.

There is a third unrecognizedtheory that can be labeled the "buyer of last resort" theory of reservecurrencies. Put bluntly, the tribute other countries pay the US through theirtrade surpluses is the result of their failure to generate adequate consumptionspending in their own markets, be it due to poor income distribution or baddomestic economic policies. This forces other countries to rely on the Americanconsumer.

The logic of this third theoryis easily illustrated. Over the last decade, while Europe and Japan stagnate,the US has grown on the back of robust consumer spending. This spending hassucked in imports, helping growth in Europe, East Asia and Latin America, andmaking the US the major engine of global growth.

East Asian countries, especiallyChina, have been particularly willing to run trade surpluses with the US becausethis has fuelled export-led growth. These countries rely on exports to keeptheir factories operating. Export success then attracts foreign directinvestment that advances development. Undervalued exchange rates are vital forthis strategy as it keeps exports competitive. Countries have thereforechanneled their trade surpluses into dollars, keeping the dollar overvalued andenabling them to sell in the US market. This explains both the continuing strongdemand for dollars despite the US trade deficit and the dollar’s dominance inofficial foreign-exchange holdings.

Ironically, America’sdispensation from trade-deficit discipline stems from other countries’ failureto develop an equivalent of the American consumer. Countries want toindustrialize with full employment, but they lack adequate internal demand.Consequently, they must rely on the US market. It is also why Germany suppliesBMWs and Mercedes-Benzes in return for paper dollar IOUs.

Conventional theory says thedollar will only lose its dominance when countries become saturated with dollarholdings. At that stage they will cease buying and may even sell dollars,causing the currency to fall. The problem with this story is that countries haveno incentive to sell dollars, as this would kill the golden goose of export-ledgrowth.

The buyer-of-last-resort storysuggests a different take. One reason the dollar could topple is if countriesfinally manage to develop their own consumption markets. Countries in the Eurozone are most capable of doing this, but for the moment they are gripped bypolicymaking that is obsessed with inflation and afraid of growth. China needsto improve its income distribution in a way that links income distribution toproductivity. Unions are the natural way to do this, but are blocked byChina’s totalitarian political system that fears such organization.

An alternative source ofcollapse is if American consumers reduce spending because they feeloverextended, the Fed raises interest rates too high or American banks tightenlending standards. In this event, the US economy would stall and the dollarcould fall owing to diminished economic prospects in the US.

All three theories have merit,but in today’s economic environment the buyer-of-last-resort theory isespecially relevant. As long as other countries fail to generate sufficientdemand in their own markets, they will be compelled to rely on the US market andpay dollar tribute.

However, none are well served bythis co-dependence. Other countries resent the special situation that exemptsthe US from trade-deficit discipline. Side by side, the long-term economicprospects of the US are undermined by the erosion of the manufacturing sector,while US workers face wage and job pressures from imports that are advantaged bythe dollar’s overvaluation. Moreover, all are vulnerable to a sudden stop ofthe system resulting from financial overextension of the US consumer.

This suggests that the rest ofthe world needs to develop an alternative to the US consumer. That will requireraising wages in developing economies, and encouraging consumption in Europe andJapan. Such measures would stabilize the global economy by providing a secondengine of growth, and it would also correct the large global financialimbalances that have developed as a result of over-reliance on the US consumer.

Thomas Palley runs theEconomics for Democratic and Open Societies Project, and is the former chiefeconomist of the US-China Economic & Security Review Commission. He is theauthor of Plenty of Nothing: The Downsizing of the American Dream and theCase for Structural Keynesianism (Princeton University Press, 1998).Rights: © 2006 Yale Center for the Study of Globalization. YaleGlobal Online