The Curse of the Reserve Currency

I’m familiar with the US dollar as the world’s reserve currency through a conventional lens. As a deliberate bargain between the US and the rest of the world.

It goes something like this:

The US enjoys a stable currency effectively lowering her cost of capital. In exchange, US Naval might enforces order on maritime trade routes. The safety of shipping lanes is a global good lifting all economies through the efficiencies of comparative advantage and arbitrage. This global good would be difficult to coordinate without a single cop like the US so the world accepts this bargain as reasonably fair even if it might nitpick aspects of it.

If you are a just being introduced to this idea you can see my notes on:

I recently read a different perspective on this global arrangement. In this alternative view, the status quo was not an explicit or even implicit deal between the US and the rest of the world but an emergent phenomenon. The distinction is important because the force that maintains it is not international diplomacy shaped by national interests. Instead, it is simply the position at which the equilibrium is at rest according to economic gravity. The invisible hand working bottom-up not authority working top-down.

Yakov Feygin and Dominik Leusder explain:

The dollar system evolved not as a tool of imperial statecraft, but as the project of a transnational elite that has effectively usurped control of an international public good.

Frameworks for understanding the persistence of the dollar system tend to vary from from reductionist to outdated, often examining international politics with discrete nation states as the main unit of analysis. In this view, the dollar is a product of hegemonic US interests, wielded as a tool of statecraft. But global financialization has upended this framework: elite interests are not aggregated domestically but internationally, and are transmitted via the balance-of-payments mechanism and the financial system…Herman Mark Schwartz, one of the foremost experts on the dollar and American hegemony, offers a better way to think about the dollar—namely, as the state money of a quasi-imperial global system, in which the different economic regions are tied together by a shared reserve currency. This ‘imperial currency’ is more of a by-product, and less of an enabler of (or even an enabling constraint on) American expansionism and military adventurism, both of which preceded the reserve currency status of the dollar.

In this version of world order, the status quo is not actually to any nation’s benefit but to a political and economic class whose interests transcend sovereign borders. This leads to a counterintuitive conclusion:

to the extent that the world has prospered since Bretton Woods, it is in spite of, not due to, the USD being the reserve currency.

The full case is laid out in The Class Politics Of The Dollar System (Link)

My Selected Excerpts And Notes

The Soft Power Of Issuing The Reserve Currency

Two clear geopolitical advantages accrue to the US because of its reserve currency status:

  • Sanctions

  • Dollar liquidity swap lines

The source of the Federal Reserve’s power over the eurodollar system—and the vulnerability of emerging markets within it—is the global reliance on central bank backstopping. In the 2008-9 crisis, the Fed deployed so-called central bank liquidity swap lines to backstop the global system. These took the form of reciprocal currency arrangements between central banks: The Fed replenished the dollar reserves of other central banks in exchange for local currency. The real power of the swap lines is not who gets them but rather who doesn’t. In a recent piece for the Nation, Andres Arauz and David Adler highlight how these swap lines can be used for a form of monetary triage, in which the United States decides which countries have better prospects for weathering economic storms.

Questioning the Narrative

Despite the advantages, dollar eminence should not be a goal. The long-run cost outweighs the near-term benefit.

Dollar primacy feeds a growing American trade deficit that shifts the country’s economy toward the accumulation of rents rather than the growth of productivity. This has contributed to a falling labor and capital share of income, and to the ballooning cost of services such as education, medical care, and rental housing. With sicknesses like these, can we say for certain that the reserve currency confers substantial benefits to the country that provides liquidity and benchmark assets denominated in that currency?

How The Plumbing Works

Offshore dollar pools depend on the liquidity of treasuries and near substitutes as collateral to raise cash in the event of a margin call.

The reason for these dollar pools is twofold. First is the need to fund trade. The Eurodollar system facilitates trading relationships between countries with different currencies by giving them access to a common stable currency in which to denominate trade—the dollar. Dollar credit allows the execution of contracts without actual, US-issued currency being exchanged. Instead, the system functions as an exchange of IOUs to deliver receipts at various periods of time.

Because 80% of trade in emerging market economies is denominated in dollars, firms with receipts in a domestic currency acquire unsustainable debt in dollars if the domestic currency falls. For this reason, central banks attempt to stockpile dollar assets, most commonly US debt. To acquire them, they usually run a persistent trade surplus by repressing the real wages of their workers. (I need more clarification on this point)

This might be sustainable in the short run, but in the long run, it leads to periods of economic stagnation, or international trade and currency wars.

The second driver of these offshore dollar pools is wealth inequality and outsized corporate returns. Large corporations, pension funds, and extremely wealthy individuals cannot bank their money in the retail banking system. Instead, they hold them in pools of dollar liquid denominated assets that can be converted into dollars quickly. While this ‘shadow banking’ system has legitimate uses, it also facilitates tax evasion and kleptocratic corruption.

The dollar system thus facilitates and fuels the power of elites who have an interest in maintaining the status quo. A globalized system with a dominant key currency aids the accumulation of rents at the expense of higher consumption from workers in exporter countries and the hoarding of those rents in the legal black hole of offshore finance.

Zooming In: How It Hurts The US

  • Financial “Dutch Disease”

    Talent or ample resources have a downside. Some might even say a curse. It can make you lazy or overly reliant on your intrinsic advantage. Here’s the idea applied to USD dominance.

    Demand for high quality dollar-denominated assets saddles the United States with a financial ‘Dutch Disease’; a situation in which the reliance on exporting a single commodity raises the exchange rate and thus squeezes out the production of tradeable, value-added goods in favor of services and financial rents….Dutch diseased economies often result in a shrinking, narrow elite whose power rests on income from sales of the single commodity, or the services and management that bloom around the cash flows generated by this commodity. For the United States, this single commodity just happens to be the dollar.

  • The evidence

    The most visible cost of the disease is the steady appreciation of the dollar since the 1980s, despite a falling US share of global gross domestic product. The main domestic symptom has been the rising costs of non-tradable goods—such as medicine, real estate rents, and education—over tradable goods. This disconnect is at least in part responsible for the country’s low rate of inflation, falling wage share, and increased economic insecurity despite access to a wider range of consumer goods. While the American consumer can now purchase an ever-expanding set of appliances, electronics, and small luxuries, services that are necessary for economic mobility and household sustainability are increasingly out of reach.

  • MMT as full blown financial Dutch disease

    Justin Czyzsczewski writes:

    In the MMT view, there is no recourse against a government going off the rails. Some developing countries are said to suffer from a “resource curse“, when an abundance of natural resources means the government doesn’t rely on taxes, and so becomes unresponsive to the wants and needs of the populace. In the past, kings with powerful armies ruled in the same way. There is a very real risk of the same phenomenon when government spending becomes untethered from taxation.

Zooming In: How It Hurts Developing Nations

  • The need to hoard dollars crowds out productive domestic investment

    For the rest of the world, the ills are clear enough. In developing countries, the need to insure their economies against currency crises and debt deflation has meant the accumulation of dollars at the expense of necessary domestic investment. These policies are usually accompanied by a suppression of consumption and incomes to establish a permanent trade surplus vis-à-vis the dollar system.

  • Dollar liquidity lowers the cost of corruption

    The dollar system allows corrupt elites to safely transport their ill-gotten earnings to global banking centers located in jurisdictions with opaque ownership laws.

While the dollar system has undoubtedly had a disproportionately negative effect on developing countries, the main fault lines that emerge from the dollar system are along class, rather than national lines.

In other words, a rich Chinese national has more in common with the US elite than their fellow citizens.

Obstacles and Remedy

  • Elites’ preference for status quo

    Developed world exporters like Japan and Germany also maintain a growth model based on cost competitiveness and wage suppression. An increased role for the Euro or the Yen would undercut these models. For resource exporters, it facilitates corruption and tax evasion through simple capital flows. In the United States, it benefits financial industry elites, who can reap the rewards from intermediating capital inflows into US markets, while the cost of non-tradable services like tuition, healthcare and real estate rises for everyone else. Across all countries, elites win.
  • Reducing Inequality

    Too great a share of the national income is in the hands of high-saving entities with dollar liquidity preferences, such as high net worth individuals and large corporations. To reverse this imbalance, income would have to be transferred from these powerful interests to China’s workers—a dynamic described by Albert Hirschman as early as 1958.

The fact that the dollar system is primarily based on social, rather than geopolitical conflict means that the best solutions suggest at a reform of the system in a manner that empowers people at the bottom of the global social hierarchy.

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