The Indirect Effects of the Dollar As Reserve Currency

Paul Krugman has a post on how holding the world's reserve currency gives the U.S. economy no great advantage. As I've written before, I think he's right on the economics (it seems to be the consensus view), but there's a few points worth adding:

1. While it may not be especially important for the world's reserve currency to be the dollar, it is important that there is some global reserve currency. And it is important that it be controlled by a central bank that is willing to inject liquidity into the global economy during periods of stress, and serve as an international lender of last resort. Call this Kindleberger's Law. Right now, the U.S. Fed seems to be the only central bank that is able and willing to serve that role.

2. More broadly, I wonder if international monetary economists are asking the wrong question. Rather than trying to quantify how much the "exorbitant privilege" is worth to the U.S., why not look at how other countries respond to policy changes in the U.S.? Putin says the "dollar zone" includes the entire globe, and so the whole globe has ideas about how the U.S. should conduct its monetary policy. Brazil imposes capital controls when the U.S. pursues monetary easing, China holds $1tn or more in reserves and has oriented its entire macroeconomic policy to respond to the U.S., South Korea put exchange rates at the top of its G20 agenda, etc. This suggests that the effects of U.S. policy choices are much more important than getting a few billion from seniorage and foreign holdings of dead presidents.

3. This foreign reliance on the U.S. gives us quite a lot of domestic policy flexibility. We're not constrained by the "small open economy" models in the ways that South Korea is, for example. If our major trading partners are pegging to the dollar, then we're not constrained by the trilemma, either. We can pursue expansionary monetary policy when and how we like. We have essentially no currency risk, S&P downgrade notwithstanding. This policy flexibility is worth much more than the $25 billion a year that Krugman estimates.

4. It also reinforces the centrality of the U.S. in the international economic system, which not only provides the U.S. with cheap capital when we need it ("flight to safety"), but also gives us a lot of leverage in global governance negotiations. In other words, it allows us to skew the rules to suit our preferences to a greater degree than other states. This is obviously not an absolute power, but neither is it negligible (to the extent that global governance is not negligible, that is). South Korea was not able to get an exchange rate agreement at the G20, because the U.S. has no reason to comply. The U.S. has a large impact on global real exchange rates, so when it wants to devalue it can, even when other countries maintain nominal pegs.

These are mostly indirect effects that a simple analysis of "value of having the reserve currency" would likely miss. And it may be impossible to accurately measure. But these factors should not be ignored. They shape the politics that shapes the broader global macroeconomy. And we've seen plenty of evidence that this effect is not small. The world's emerging markets have been upfront in their desire to move to a multilateral reserve currency, such as the IMF SDR, that would give them more influence in managing the international monetary systems. They've also pressured the IMF to concede that capital controls can be a legitimate policy response to U.S. monetary easing, and have built massive piles of reserves. This indicates how important U.S. monetary policy is to the world, which should give us some indication of how important it is for us.

On the Dollar, Euro, and RMB

I had been planning on blogging about Barry Eichengreen's recent book-hype talk -- about the coming decline of the dollar as pre-eminent global currency (see here and here, for examples), and the rise of the Euro and RMB as its replacements -- but I haven't had the time. Thankfully, Michael Pettis wrote a characteristically long, thorough post on why that won't be true (for the RMB at least) any time in the foreseeable future. Highly recommended. The gist:

1. In order for China's currency to become a significant international reserve currency, even at the level of the yen, its internal economy would have to go through wrenching reforms.

2. China's financial system cannot handle the international competition that would come from capital account liberalization.

3. China has no reason to want the RMB to be a reserve currency, at least as long as it thinks it can benefit from the export-led growth that comes from a low peg to the dollar.

Pettis also notes that everyone was saying the same things about the yen knocking off the dollar 20-30 years ago. And while the yen is an important international currency, it's just not in the same league as the dollar. Pettis is higher on the Euro (I'm not, at least not for another decade), but acknowledges that for that to happen the Euro will likely need to first kick some members out. Right now, dollar holdings are about 250% higher than Euro holdings despite the fact that the EU has a larger cumulative economy, and obviously the Euro has things to work out before full confidence is restored.

Pettis also explains why having the world's reserve currency isn't always good for the U.S., and can be very good for other countries, especially those that pursue growth via exports. Which then begs a question: if the U.S. is willing to provide a public good at its own expense, and other countries benefit from that, then why wouldn't the dollar persist as the pre-eminent global currency? A move away from the dollar would represent a redistribution to the U.S. from other countries relative to the status quo. It seems like those countries would be happy to take advantage of that situation as long as they are able. It's true that the U.S. is able to fund its debt cheaply because of the high demand for dollars, but that would be true even if it didn't issue the largest reserve currency. Other advanced industrialized countries pay the same rates, or in some cases less, on their bonds than the U.S. does, and they are able to borrow in their own currencies as well.

In other words, there isn't any particular reason to expect the international monetary system to change much, especially in the short run, most likely because of positive feedback loops. The dollar's status as reserve currency isn't primarily an indication of the U.S.'s current or future economic performance, it's an remnant of its past role at the center of Bretton Woods. And while the U.S. gets some privilege from issuing the reserve currency, it isn't all that exorbitant. The international monetary system benefits from having a universally convertible currency, no matter what it is. So the dollar is the reserve currency, and will remain the reserve currency, mostly because it has been the reserve currency.

If that's the case, then the dollar's role as the pre-eminent reserve currency is likely a stable equilibrium for some time to come.

Relative Prices and the Real Estate Bubble

Megan McArdle asks, Why did investment in real goods and services suddenly become so much less attractive than housing?" I suggest the answer lies in four words: real exchange rate appreciation.

Why would real appreciation divert capital to real estate? Think of the economy as composed of two sectors, the traded sector and the non-traded sector. When the currency strengthens, traded sector activity suffers. It becomes more difficult to sell American products abroad, and foreign products sell cheaply in the US market. Hence, anyone who makes traded goods is going to struggle. Non-traded sector activities do not face international competition, and thus do not suffer such competitiveness problems under a strong currency. In fact, if you earn your income in non-traded activities and consume lots of traded goods and services, then a strong dollar actually works to your advantage because it reduces the price of the things you buy while having little impact on your nominal wage. All of which we can summarize by suggesting that the return to non-traded activity rises relative to traded activity as the currency strengthens.

Consequently, if you are looking to invest hundreds of millions in the American economy in 1998-2006, are you going to invest in auto production and other traded sector activities or are you going to invest in real estate and other non-traded sector activities? The figure at the top of the post suggests that the answer should be rather obvious. The dollar appreciated in real terms against a weighted basket of the US's most important trade partners by 20 percent or so between the late 1990s and the early naughts. Consequently, investment in non-traded activities was much more attractive than investment in traded sector activities (with the obvious exception of investment in financial services).

All of which makes one wonder why the dollar strengthened so sharply in this period. But that is a topic for another day.

*Real Effective Exchange Rate indicies from Economic Report of the President, Table B-110

A Thousand Words

Left vertical axis: total U.S. exports, seasonally adjusted, in millions USD (source: BEA)
Right vertical axis: value of U.S. dollar vs. a basket of major foreign currencies (source: St. Louis Fed)

Something about Dr. Oatley's analysis below didn't seem right to me. Have a look at the graph above. Obviously, one graph doesn't prove or disprove anything, but a first glance at recent history seems to indicate that U.S. exports and the value of the dollar are negatively correlated. In other words, as the value of the dollar declines, exports rise. Or, in the language of the post below this one, it seems that the demand for U.S. good is sufficiently responsive to price changes -- i.e. demand is sufficiently elastic -- to produce an increase in exports as the value of the dollar decreases.

Now whether a dollar devaluation would lead to a net benefit to the U.S. is an open question, because (as Dr. Oatley pointed out) a weakening dollar also means a decline in relative national income. But with the economy in less than full employment, it seems that a moderate weakening of the dollar could generate some welfare gains by spurring the utilization of presently dormant resources.

Like I said, one graph doesn't prove or disprove anything. But this is one piece of evidence showing that demand for U.S. goods is not strongly inelastic. And if that's the case, then U.S. policymakers are acting rationally to seek a moderate devaluation of the dollar in order to boost employment. Unfortunately, if it's rational for the U.S., it's also rational for other governments, and a series of competitive devaluations will lead to even greater economic ruin.

(This says nothing about the capital inflows -- made necessary by running a current account deficit -- which helped fuel the dot com and subprime bubbles. Perhaps more on that later.)

Fannie, Freddie, and International Relations

Fannie Mae and Freddie Mac, the quasi-private investment groups that own or guarantee roughly half of the U.S. mortgage market, have now effectively been nationalized. The purpose of this blog isn’t to run-down all of the domestic effects of this (for that, see Brad DeLong and Calculated Risk, and keep in mind that Fannie & Freddie own or guarantee about $6 trillion in American mortgages), but there are implications for IPE study as well.

For example, central banks, sovereign wealth funds, and other international investors bought heavily into Fannie Mae and Freddie Mac, because they were under the impression that the investments were as close to riskless as one could get*. As Treasury Secretary Paulson noted, nearly $5 trillion in Fannie/Freddie debt and securities are owned by investors all over the world. To put that into perspective, the combined GDP of the U.K. and Italy in 2007 was less than $5 trillion. There is simply no way that the U.S. Treasury could let the companies fail and allow those nations (and other investors) to take a hit that big. If they did, says Tyler Cowen, the effects would be catastrophic:

The flow of capital from them and from other central banks, sovereign wealth funds, and plain old ordinary investors would shut down very quickly. The dollar would fall say 30-40 percent in a week, there would be payments system gridlock, margin calls at the clearinghouses would go unmet, and only a trading shutdown would stop the Dow from shedding half its value. Most of the U.S. banking system would be insolvent. Emergency Fed/Treasury action would recapitalize the FDIC but we would lose an independent central bank and setting the money supply would be a crapshoot. The rate of unemployment would climb into double digits and stay there. Many Americans would not have access to their savings. The future supply of foreign investment would be noticeably lower. The Federal government would lose its AAA rating and we would pay much more in borrowing costs. The deficit would skyrocket.

Tyler Cowen isn't known as a pessimist, but considering that “when the U.S. sneezes, the world gets a cold,” the prospects for international financial markets as a whole could have been catastrophic if the U.S. had not acted. In short, it’s likely that international political concerns, such as maintaining the credibility of the U.S. government in the eyes of other foreign nations, have essentially forced the Treasury Department to step in, even if they didn’t want to.

The news of nationalization was greeted warmly by nearly everyone. The announcement was made yesterday for the benefit of foreign financial markets trading overnight, and those markets responded by posting large gains. The heads of the European and Japanese central banks spoke positively of the take-over. There is still some pain ahead, especially for domestic banks, but by nationalizing Fannie and Freddie the U.S. Treasury may have dodged a bullet. At least temporarily.

*As it turns out, they were right: these investments were largely riskless since the implicit guarantee of the debt by the U.S. government has now turned into an explicit guarantee. Are there moral hazard concerns? You betcha. But, as the saying goes, "in the long run, we're all dead."

[UPDATE: U.S. markets posted huge gains today in response to the bail-out news. The dollar gained against the Euro, Pound, Swiss Franc, and Yen.]

Petrodollars '00 Style

Petrodollars played a key role in the genesis of the Latin American debt crisis during the 1970s. Today's NYT examines how oil exporters are using their windfall from the current oil price rise. How big a windfall, you ask? "In 2000, OPEC countries earned $243 billion from oil exports, according to Cambridge Energy Research Associates. For all of 2007 the estimate was more than $688 billion, but that did not include the last two months of price spikes." On average, oil exporters are earning $1.8 billion per day.

Seems that oil exporters are pursing a more diversified investment strategy today than they did during the 1970s; rather than deposit the funds in Citibank, they are now buying big shares of Citigroup (Abu Dhabi is now the single largest share holder). More broadly, "the oil-rich nations are...investing more in real estate, private equity funds and hedge funds, analysts say, and increasingly they are investing the money on their own, bypassing the major financial institutions of the United States and Europe."

Interestingly, oil exporters, like China, are a bit uncertain about what to do in response to a weakening dollar. Some advocate shifting out of dollar-denominated assets in response to the falling dollar; others fear that shifting into euro-denominated assets will cause the dollar to weaken further, thereby reducing the value of the dollar-denominated assets they have accumulated.

The Soaring Euro: Imitation is the Sincerest Form of Flattery

American exchange rate policy during the last 40 years has leaned heavily on a simple strategy: unwilling to use US monetary policy to influence the dollar's external value, it has sought to induce other governments to alter their policies. The logic, of course, is simple. All bilateral exchange rates are a function of the interaction between two monetary policies, and thus the exchange rate can be influenced via changes in either policy. During the 1960s and early 1970s, the US pressured (or, as one of my current [German exchange] students put it in class, coerced) Germany to accumulate and hold dollars to shore up the Bretton Woods System. During the 1980s, the US pressured Japan and, to a lesser extent Germany, to realign the mark-yen-dollar triangle. Currently, the US pressures the Chinese to revalue.

The EU seems to be embracing this policy as if they had invented it themselves. Sarkozy, during his recent visit to the States, scolded Congress and demanded the US take steps to stem the dollar's slide or face a trade war. An EU delegation is headed to China to pressure (coerce?) the Chinese to revalue the yuan. All of this on the heels of the ECB's decision that it prefers to keep interest rates steady, thereby refusing to use interest rates to stem the euro's rise.

EU tactics seem a direct consequence of monetary union. Fifteen years ago the French would have screamed at the Germans and then probably devalued the franc. Now, it does no good to scream at the Germans (althought Sarkozy did try that first, I guess old habits die hard), and the French can't devalue. Nor can they directly control ECB monetary policy. The only way to influence the euro's external value, therefore, is to pressure other governments to adjust their policies.

I had always considered American policy a consequence of American structural power and isolationism. The EU's embrace of this strategy makes me wonder if American policy isn't also a product of institutions, especially the independence of the Federal Reserve.

Krugman on the Dollar and Current Account Adjustment

I do like it when Paul Krugman uses his platform to talk about the things he knows best, in this case, current account adjustment and the falling dollar. It also is not everyday that one sees a public discussion about the savings-investment gap, so it's worth checking out for that reason alone..

Krugman has written two recent blog posts on this topic, one that emphasizes the need for a depreciating dollar in conjunction with rising savings, and another on the reasons for the dollar's current slide. The basic message is that current account adjustment without recession requires a rise in savings and a fall in the dollar. He elaborates these views in greater detail in a recent Economic Policy article (a shorter piece apparently derived from this by Robert Baldwin is also available).

The Dollar and the Housing Market, Again

1. One simple expectation: a real exchange rate appreciation raises the return to non-traded goods relative to traded goods. The intuition is straight forward: as the currency gains value, prices of manufactured goods (traded goods) fall, while prices of goods and services that do not readily cross borders (houses, for example) do not. Consequently, as a currency appreciates, people ought to invest less in the traded goods sector and more in the non-traded goods sector.

2. Two Simple Graphs:
A. Graph 1 (top) shows the dollar's substantial appreciation in real terms between 1995 and 2003; the dollar remained high relative to the early 1990s until 2005.
B. Graph 2 (bottom) shows the substantial increase in housing prices that began in 1995 and peaked in 2005.

3. One simple hypothesis: The real estate bubble was at least in part a consequence of the dollar's sharp real appreciation between 1995 and 2005.

4. One simple extension of temporal scope: Notice that the 1980s real estate boom also occurred in a strong dollar era.

5. Broader point: the Fed's current dilemma--target the dollar's external value or target the financial system--is merely the continuation of a deeper problem. The low-interest rate policy of the early 00s fed the housing bubble, but higher interest rates at that time would have yielded an even stronger dollar (and hence stronger incentives to shift into non-traded goods). Lower interest rates might have slowed the dollar's rise, but also fueled an investment boom somewhere else. Hence, pick your poison.

The deeper problem, of course is that the Fed has two policy targets (the exchange rate and the domestic economy) and only one policy instrument. The policy appropriate to meet one target is not always appropriate (and can have perverse consequences) for the other.

Weak Dollars, Subprime Messes, and Monetary Policy Dilemmas

When does the dollar's depreciation become serious? When Chinese officials start talking in public about shifting its $1.43 trillion of reserve holdings out of dollars and into other currencies. The markets are already a bit skittish; loose talk does not help.

Can the U.S. do anything to bolster the dollar? It appears that the U.S. is caught between the classic rock and hard place. On the one hand, domestic financial difficulties resulting from the subprime mortgage mess has encouraged the Fed to cut rates and inject liquidity to ease market conditions. Rate cuts and extra liquidity, however, weaken the dollar. If the Fed wants a stronger dollar, the required higher rates will squeeze financial institutions. Not much of a choice; bolster the dollar at the short-term cost of worsening the financial crisis; inject liquidity at the short-term cost of a weaker dollar.

The Fed's current dilemma is hardly unique. It is not fundamentally different than the dilemma Thai and Indonesian governments faced in 1997; not fundamentally different than the dilemma Austrian authorities faced in 1931. Not fundamentally different from the dilemmas posed by financial crises throughout history (the 1907 and 1894 panics come to mind as well). In all of these cases, monetary authorities had to choose between actions that saved key domestic financial institutions and actions that stabilized the currency. Yes, the contemporary US is different--no fixed exchange rate as a focal point for speculation; no precious metal reserve constraint--yet still, it must choose between internal and external objectives.

What surprises me is that even those at the Fed who oppose further rate cuts make no mention of the dollar as a reason for their resistance.

Who Sets American Exchange Rate Policy?

A reader posed a question in a comment on an earlier post: "LeMonde today had a long op-ed on the European reponse to the high Euro and in it the author claimed that "La politique de change americaine est du seul ressort de la Maison Blanche, la Fed n'ayant pas son mot a dire sur le sujet." (Exchange rate policy is a White House resort only, the Fed does not say a thing about this). This confuses me. I thought interest rates were the main leverage of nations to impact exchange rates and those are clearly left to the Fed. So how can the White House be responsible for the exchange rate if they cannot regulate it in anyway?"

This is a good question; the short answer is that the Treasury and the Fed have separate authority to engage in foreign exchange market intervention. Treasury (executive branch) appears to have the upper hand. Yet, the Fed also has legal authority over interest rates. Practically speaking, then, the question of who controls exchange rate policy depends upon whether forex intervention is an effective instrument. As most economists seem to agree that it is not (which is why the US rarely engages in forex intervention), then practical authority would seem to lie with the Fed via their control of interest rates.

It is not altogether clear who has final say in the event of a conflict between exchange rate and domestic monetary objectives--can the Treasury force the Fed to expand the money supply to depreciate the dollar? Can the Fed force the Treasury to accept a dollar value in order to achieve its domestic monetary goals?

I think that exchange rate policy in the euro zone is similarly ambiguous; the ECB controls monetary policy while the Council of Ministers has the authority to set broad exchange rate objectives. What happens, who has ultimate authority, when they conflict is unclear. (on the ECB and Council, see here, Article 109).

Here's a longer (and more authoritative) answer from the New York Federal Reserve Bank (page 87):

By law and custom, the Secretary of the Treasury is primarily and directly responsible to the President and the Congress for formulating and defending U.S. domestic and international economic policy, assessing the position of the United States in the world economy, and conducting international negotiations on these matters. At the same time, foreign exchange markets are closely linked to money markets and to questions of monetary policy that are within the purview of the Federal Reserve. There is a distinct role and responsibility for the Federal Reserve,working with the Treasury and in cooperation with foreign central banks that operate in their own markets. For many years, the Treasury and the Federal Reserve have recognized the need to cooperate in the formulation and implementation of exchange rate policy.

The Treasury and the Federal Reserve each have independent legal authority to intervene in the foreign exchange market. Since 1978, the financing of U.S. exchange market operations has generally been shared between the two. Intervention by the Treasury is authorized by the Gold Reserve Act of 1934 and the Bretton Woods Agreements Act of 1944. Intervention by the Federal Reserve System is authorized by the Federal Reserve Act. It is clear that the Treasury cannot commit Federal Reserve funds to intervention operations. It also is clear that any foreign exchange operations of the Federal Reserve will be conducted,in the words of the Federal Open Market Committee (FOMC),“in close and continuous cooperation with the United States Treasury.” In practice, any differences between the Treasury and the Federal Reserve on these matters have generally been worked out satisfactorily.

Cooperation is facilitated by the fact that all U.S.foreign exchange market operations are conducted by the Foreign Exchange Desk of the Federal Reserve Bank of New York, acting as agent for both the Treasury and the Federal Reserve System.