The reserve currency curse
Introduction
Is reserve currency status a blessing or
a curse? The answer might seem obvious, as reserve currencies have been shown
to confer lower borrowing costs on their issuers. But what of the
borrower who, enticed by low interest rates, borrows more than they can pay
back? Naturally the result will be a default. However, for the issuer of a
reserve currency that is unbacked by a marketable commodity, such as gold, in
the event that they borrow too much, they can just print more reserves. While
this avoids default indefinitely, it also hollows out the economy, erodes the
capital stock, reduces the potential growth rate and, eventually, leads to a
dramatic devaluation of the currency and loss of reserve status. History has
not been kind to countries that have followed this path, nor to their
financial markets. In my view, the grave investment risks associated with the
possible eventual loss of the dollar’s reserve status are not priced into
financial markets.
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RESERVE CURRENCIES, TRADE IMBALANCES AND THE ‘TRIFFIN DILEMMA’
Having written a book about international monetary regime change past,
present and future, I weigh in here on what is gradually becoming a more
mainstream debate about whether or not the US dollar is at risk of losing
reserve currency status; what currencies, if any, might replace it; and,
should that happen, what general economic and financial market implications
this would likely have.
As it happens, I have a rather strong opinion on all of these matters. But
first, let’s consider what a reserve currency is and what it is not. Second,
let’s distinguish carefully between reserve currencies that are backed by a
marketable commodity, such as gold or silver, and those that are not. Third,
let’s take a look at shifting global economic power and monetary
arrangements. Then we can move into what I think is going to happen in
future, what this implies for financial and commodities markets, and what
investors should do to prepare.
What, exactly, is a reserve currency? It is an international money that is
used to pay for imports from abroad and is then subsequently held in
‘reserve’ by the exporting country, as it does not have legal tender status
outside of its country of issuance. In the simple case of two countries
trading with one another, with one being a net importer and one a net
exporter, over time these currency ‘reserves’ will accumulate in the net-exporting
country. In practice, as reserves accumulate, they are invested in some way,
for example, in bonds issued by the importing country. In this way the
currency reserves earn some interest, rather than sit as paper scrip in a
vault.
Beyond a certain point, however, accumulated reserves will be perceived as
‘excessive’ by some in the exporting country, in that they would prefer to
purchase something with this accumulated savings instead. In this case they
have a choice: Either they can purchase more imports from the net-importing
country, thereby narrowing the trade imbalance, OR they can exchange their
reserves with another entity at some foreign-exchange rate. For this reason,
other factors equal, as reserves accumulate, the reserve currency will depreciate
in value.
As time goes on, trade imbalances and reserve balances grow in tandem, as
does the natural downward pressure on the value of the reserve currency as
described above. This leads to what Belgian economist Robert Triffin called a
‘dilemma’: For trade to expand, the supply of reserves must increase. Yet
this implies a weaker reserve currency over time, something that can lead to
price inflation. Indeed, under the Bretton Woods system of fixed exchange
rates, the supply of dollar reserves grew and grew, price inflation increased
and, eventually, as one European central bank after another sought to
exchange its ‘excess’ dollar balances for gold, this led to a run on the
remaining US gold stock and the demise of that particular monetary regime.
While hailed as an important insight at the time, Triffin was pointing out
something rather intuitive: Printing a reserve currency to pay for net
imports is akin to owning an international ‘printing press’, the use of which
causes net global monetary inflation and, by association, some degree of
eventual, realized price inflation. It can also result in chronic imbalances
and the associated accumulation of excessive, unserviceable debts.
‘CANTILLON EFFECTS’ AND THE NON-NEUTRALITY OF INTERNATIONAL MONETARY
RESERVES
Now let’s combine Triffin’s insight with that of Richard Cantillon, a
pre-classical 18th century economist, that money is not ‘neutral’: New money
enters the economy by being spent. But the first to spend it does so BEFORE
it begins to lose purchasing power as it expands the existing money supply.
The money then gradually permeates the entire economy, driving up the overall
price level. Those last in line for the new money, primarily everyday savers
and consumers, eventually find that, by being last in line for the new money,
their accumulated savings are being de facto ‘diluted’ and the purchasing
power of their wages diminished.
Extrapolated to the global level, this non-neutrality of money implies
that an issuer of a reserve currency is the primary beneficiary of the
‘Cantillon effect’. First in line for the new international money you have
the owners of capital in the reserve issuing countries, which use the new
money to accumulate more global assets, and on the other you have workers the
world over who receive the new money last, after it has placed general upward
pressure on prices. Growing global wealth disparity is the inevitable result.
Another way to think about the benefits of issuing the reserve currency is
that it generates global seignorage income. Federal Reserve notes pay no
interest. However, they can be used to purchase assets that DO bear interest.
No wonder the Fed always turns a profit: It issues dollars at zero interest
and collects seignorage income on the assets it accumulates in return. But in
a globalized economy, with the US a large net importer and issuer of the
dominant reserve currency, this seignorage income is largely if indirectly
sourced from abroad, via the external accounts.
This becomes particularly notable in the event that domestic credit growth
is weak relative to abroad. The Fed may print and print to stimulate domestic
credit growth but if that printing does not get traction at home, it will
instead stimulate credit growth abroad and, eventually, contribute to higher asset
and consumer price inflation around the world.
Over time, this will impact the relative competitiveness of other
economies, where wage growth is likely to accelerate, eventually making US
labour relatively more competitive. That may sound like good news, but all
that is really happening here is that US wages end up converging on those
elsewhere, something that should happen in any case, over time, between
trading partners as their economies become more highly integrated. But as
mentioned above, to the extent that this wage convergence process is driven
by monetary inflation, rather than natural, non-inflationary economic
integration, the Cantillon effects discussed earlier result in wages
converging downward rather than upward, implying a global wealth transfer
from ‘owners’ of labour—workers—to owners of capital.
So-called anti-globalists disparaging of free trade are thus not
necessarily barking mad—well, perhaps some are—but they are barking up the
wrong tree. The problem is not free trade; the problem is trade distorted by
monetary inflation. If you want workers around the world to get fairer
compensation for their labour, shut down the reserve currency printing press.
And if you also want them to have access to the largest possible range of
consumer goods at the lowest possible cost, remove trade restrictions, don’t
raise them.
RESERVE CURRENCIES, COMMODITY-BACKED AND UNBACKED
As it happens, prior to the First World War, the bulk of the world was on
the classical gold standard. Although the British pound sterling was the
dominant reserve currency, it was not possible to print an endless amount of
pounds to pay for endless imports, as external reserve currency balances were
regularly settled in gold. The British pound thus held its value over time, as
did other currencies on the gold standard, and there was not a ‘Triffin
Dilemma’ resulting in growing, unsustainable trade imbalances. Moreover,
absent monetary inflation, there were no insidious Cantillon effects taking
place. Industrial wages were generally stable through these decades, which
were characterized by mild consumer price deflation. This implied an increase
in workers’ purchasing power and standards of living. So while there are
certain parallels between sterling’s previous, gold-backed role as a reserve
currency and that of the unbacked, fiat dollar today, there are even greater
differences.
(For those curious how such a stable international economic order could
break down so completely in such a short period of time, please turn to the
extensive literature on the causes and consequences of WWI, arguably the
greatest tragedy ever to befall western civilization.)
Returning to the present, countries that have been exporting to the US and
accumulating dollars in return are increasingly getting the joke, but they
aren’t laughing. Hardly a week goes by without some senior official in an
up-and-coming country rich in natural resources or with competitive labor
costs criticizing US monetary policy while suggesting that gold should play a
greater role in international monetary affairs. The BRICS (Brazil, Russia,
India, China, now joined by South Africa), individually and together, have
already made numerous official, public statements to this effect. One can
only imagine what is being discussed in private, behind closed doors.
Back in 2012, Prime Minister Erdogan of Turkey--historically a
‘swing-state’ in its global orientation, yet currently a member of NATO and
thus at least a nominal US ally--had this to say, in criticism of the
International Monetary Fund (IMF):
The IMF extends aid on a who, where, how and on what conditions bases. For
example, if the IMF is under the influence of any single currency then what,
are they going rule the world based on the exchange rates of that particular
currency?
Why do we not switch then to a monetary unit such as gold, which is at the
very least an international constant and indicator which has maintained its
honor throughout history. This is something to think about.
Historians will note that back in the 1960s, France was also a full member
of NATO, but following President De Gaulle’s decision to challenge the
dollar-centric Bretton Woods system in the mid-1960s, there erupted a series
of dollar crises that culminated in the collapse of the Bretton Woods regime
in the early 1970s. Is history about to repeat?
(Incidentally, history has already nearly repeated at least once before,
in 1979-80. While the mainstream historical economic narrative about this
period is that the Fed resorted to punishingly high interest rates to fight
the high rate of domestic price inflation, one look at the behavior of the
dollar in 1979 and 1980 tells another story, that the air of crisis at the
time had an important international dimension. FOMC meeting transcripts also
reinforce this arguably ‘revisionist’ historical view that the dollar’s
international role was at risk.)
Clearly there is growing dissatisfaction with the current set of global
monetary arrangements, which allow the US to print the global reserve
currency to pay for imports, an ‘exorbitant privilege’ as it was termed by
another French president, Valery Giscard d’Estaing. Under the Bretton Woods
system, France or any participating country for that matter could choose to
exchange its accumulated dollars for gold. As predicted well in advance by
French economist Jacques Rueff, a contemporary of Robert Triffin, the
exercise of this choice to exchange dollars for gold by not only France but a
handful of other countries led to a run on the US gold stock in 1971 and an
end to the dollar’s gold convertibility.
THE RESERVE CURRENCY CURSE IN DISGUISE
Let’s pause this discussion here for a moment. Is reserve currency status
a blessing, or a curse? The answer may seem obvious. After all, isn’t it nice
to hold the power of the global printing press? To enjoy relatively lower
borrowing costs and greater purchasing power? To possess the ‘exorbitant
privilege’, as it were? On the surface yes, but what lies beneath?
As Lord Acton wrote, “Power tends to corrupt. Absolute power corrupts
absolutely.” By corollary, absolute monetary power corrupts absolutely. And
to the extent that monetary power that is held nationally is exercised
internationally, then the corruption thereof can have a deleterious
international economic impact.
In the case of a reserve currency, the ‘benefits’ of lower borrowing costs
and cheap imports accruing to the issuing country appear to result in
overborrowing and overconsumption relative to the rest of the world, eroding
the domestic manufacturing base over time and widening the rich-poor gap to
levels that are socially destabilizing. Trade wars, currency wars or other
forms of economic conflict are the typical result. In some cases, actual wars
follow. In others, they don’t. But in all cases, the reserve currency curse is
recognized only too late, when an economy begins consuming its own capital in
a desperate and unsustainable attempt to maintain its previous standard of
living. Austrian economist Ludwig von Mises described capital consumption as
akin to “burning the furniture to heat the home.” Sure, it might work for a
time, but what comes next? The walls? The floorboards? The roof?
For those who think that a capitalist, free-market economy would never
willingly consume its own capital, you may be right. But what of an economy
that merely pretends to be capitalist and free market, but that sets the
price of money by decree at an artificially low level such that there is
little incentive to save?
It is highly intuitive to reason that, if an authority mandates a price
ceiling below the natural, market-determined price for a given product, less
of it will be provided and a shortage will result. Holding the ‘price’ of
money—the interest rate—artificially low over a sustained period of time
leads to a shortage of savings and, thus, to low rates of investment net of
depreciation. Severely low or even negative rates would almost certainly lead
to capital consumption and, unavoidably, a lower standard of living in time.
Notwithstanding the power of basic economic logic and empirical evidence
of historically low rates of fixed (non-inventory) business investment, the
US Fed may honestly believe that its neo-Keynesian models are right.
Alternatively, even though its forecasts of recovery have been off the mark
for many years, perhaps it is simply not willing to admit that the models, or
the entire theory, are wrong. Back in 2012, the International Monetary Fund,
for what it is worth, already determined that its models are flawed, although
they also admitted they had little idea what to do about it other than to
shoot in the dark, something that is not exactly reassuring.
THE TURKEY IN THE GOLD MINE
Today, as the dollar is not convertible into gold, there could not be a
run on the US gold stock. But there is no reason why central banks around the
world can not diversify out of dollars and into gold, something that would
have much the same result: The dollar would decline versus gold and real
assets generally, US imports would become more expensive and economic growth,
to the extent that the US can grow at all given its structural problems at
present, would be highly ‘stagflationary’, just as was the case during the
1970s, in the aftermath of a substantial dollar devaluation.
As it happens, these developments are already underway. According to
various reports, many central banks have been and continue to accumulate
gold, including Russia, China, Brazil, India, Bangladesh, Mexico, South
Korea, Kazakhstan Turkey and Indonesia. While central banks must report their
gold reserves to the IMF, the sovereign wealth funds of these countries are
under no such obligation and, as sovereign wealth funds occasionally operate
in effective if unofficial collaboration with their respective central banks,
it is highly likely in my opinion that there is much more official gold
accumulation taking place than is officially reported.
As they are not free-market, profit-maximizing entities in the same sense
as independent private investors, these official gold buyers are not as price
sensitive. If they are instructed by their political leadership to diversify
their reserves out of dollars in some amount, or at some regular rate, they
are going to carry out that mandate, regardless of the price, until that
policy changes. This is strategic, not tactical gold buying, as it were.
This is just one of many reasons why the gold price has resumed an
uptrend. The most fundamental is simply that the values of currencies, now
including the dollar for the first time in awhile, are going down as a result
of endless quantitative easing (QE), negative interest rates or other forms
of monetary expansion. That the agents swapping their dollars for gold happen
in some cases to be price-insensitive official institutions is just one
mechanism by which a global shift out of paper into hard assets has been an,
in my opinion, will continue taking place.
I don’t pretend to know exactly what is going to happen from one day to
the next. But when you step back and see the larger picture of one country
after another expressing disapproval with the dollar reserve standard, you
can’t help but notice that the game is changing. Central bank or other forms
of official gold buying is but one aspect. Another is the growing official
collaboration on monetary and other economic matters by the BRICS. Then there
are the various bilateral currency arrangements between an increasingly
number of countries that allow them to reduce dependence on the dollar for
bilateral trade.
Turkey’s previous admission that it was paying for imports of Iranian
natural gas with gold in order to avoid US sanctions may seem a small,
insignificant development by comparison but within the larger context it
could have a disproportionate impact. Indeed, Turkey may have been only one
of several countries monetizing gold for use in importing Iranian gas or
other goods. As a canary signals danger in a coal mine, might Turkey be
signaling something rather more significant for international monetary
relations?
Quite possibly. Game theory is highly instructive as to how international
policy regimes, once destabilized by changing conditions or incentives, can
suddenly shift to, or collapse into, a new equilibrium, sometimes in response
to seemingly insignificant developments. When countries that comprise in
aggregate about 1/3 of all global trade flows express dissatisfaction with
the dollar and the IMF, the current international monetary regime is clearly
unstable. When a medium-sized player such as Turkey moves from one side of
the game board to the middle, or to the other side, there is always a chance
that this represents the proverbial ‘tipping point’ from one equilibrium to
another. In this case, if history is a guide, then as the world moves away
from the current, dollar-centric reserve standard system it will move to one
based on multiple currencies, yet with an explicit reference to gold.
Why gold? Part I of my book, The Golden Revolution, concludes with a
discussion about why gold has by far the strongest claim as a future
international monetary reserve replacement for the dollar. While historical
precedent is important, there are also two important theoretical points to
consider. First, there is no existing fiat currency alternative to the dollar
at present, in the way that the US dollar provided an obvious alternative to
the pound sterling following WWI. Second, given the increasingly obvious
breakdown in cooperation in international monetary relations, it is highly
unlikely that, as the dollar’s role diminishes, there could be a universal
agreement about how to construct or implement a global currency alternative
to the dollar. Yes, the IMF has proposed precisely this and (no surprise
here) has put itself forward as the bureaucracy that could manage it, but as
discussed above, Turkey, the BRICS and a handful other nations don’t necessarily
trust the IMF to act in their national interest.
As a medium of exchange that cannot be printed, devalued or otherwise
manipulated by any one country to somehow exploit others, gold holds more
than just a historical claim to a future role as international money. It
provides a basis for mutually-beneficial international trade when trust in
monetary stability in general is lacking, as is increasingly the case today.
The answer to the question of what currency or currencies can provide the
future international reserve is thus as paradoxical as it is elegant: Every
currency, if linked to gold, and none, as gold itself provides the trust.
The classical gold standard was so successful for this very reason. As the
industrial revolution spread globally, cross-border trade and investment
volumes soared. Without stable prices, however, high rates of investment
would have been short-lived or completely unobtainable as businesses would
have had insufficient confidence to take the long-term, cross-border risks
required to develop what were becoming multinational industries and the first
properly multinational firms. Indeed, it is difficult to imagine how the
Industrial Revolution could have occurred at all, if not on a sound monetary
foundation. Imagine otherwise, that 18-19th century industrialists had faced
the uncertainties associated with zero-rates, currency volatility, QE or even
negative rates. No doubt they would have mostly sat on the sidelines and
hoarded gold as many wealthy investors are increasingly doing today as they
seek to preserve wealth in a highly uncertain world.
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