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.